Dispatches from the Frontier

Innovation Maturity

Yesterday, I asserted:

For many, the collaborative capacity required to facilitate the social interfaces necessary for networked innovation will be slow to emerge.

Earlier this week, Jeffrey Phillips at Innovate on Purpose had this to say about "innovation maturity":

Innovation, like many other corporate capabilities, evolves over time and as the people involved gain understanding and knowledge...Innovation in most firms is really just getting started. To that end, it's a lot like a small child, succeeding occasionally, stumbling occasionally, learning by doing...A firm that is more focused on process excellence and cost cutting seeks ways to avoid change and risk, so you can begin to see the dynamic of a teenager and the parent...The parent (executives) want the teen to grow, but don't want to assume any costs or risks.

Open Innovation, Social Interfaces, and Collaborative Capacity

Most companies know how to cooperate; few have developed an effective capacity to collaborate.  Consequently, most companies will not be able to take full advantage of open innovation.

Consider the following propositions:

• Innovation is uncertain.  Furthermore, the accelerating clockspeed of business makes the process of innovation increasingly uncertain as it simultaneously requires ever faster rates of innovation.  Consequently, one's likelihood of success is a function of one's ability to manage a flow of qualified, prospective innovations.
• Modular systems offer valuable flexibility in the face of uncertainty.  The essence of the open innovation hypothesis is that coordinated networks of specialists perform better than highly integrated firms in the face of rapid environmental change.  Continuous exploration can be conducted by one set of specialists, and selective exploitation can be undertaken by another set.  However, modular networks require robust interfaces - protocols that allow for one module to interact with another in a timely, seamless fashion.
• Networked innovation requires robust social interfaces.  Innovation is inherently social, as are the interfaces between functional specialists.  Such interfaces are more robust to the extent that the parties share the following: an understanding of relative competencies and resources, values, and a mutual commitment to equitable rewards.

In my experience, relationships characterized by the preceding are rare.  Although collaboration is fashionable, I believe that most inter-firm behavior is best described as cooperative, per the definition offered in Collaborative Entrepreneurship:

[W]e suggest that collaboration differs from competition and cooperation in two main ways.  First, cooperation is motivated by the benefits each party expects to receive from sharing ideas, information, or resources.  Therefore, while cooperative behavior may be enjoyable in its own right, it is primarily extrinsically motivated.  Second, because cooperative behavior ultimately involves the pursuit of self-interest, it requires periodic or even continual assessment by each participant of the amount of trust and commitment of the other party.  In collaborative relationships, on the other hand, each party is as committed to the other's interests as it is to its own, and this commitment reduces the need for the continual assessment of trust and its implications for how rewards will be divided.  Because it is the innovation-generating relationship itself that is valued, collaborators can focus on its intrinsic aspects knowing full well that future returns will be equitably allocated.

I have a collaborative relationship with my partners at EIP.  EIP has collaborative relationships with its inventor-partners as well as with a majority of our development partners.  To-date, EIP has cooperative relationships with BigCos.

The development of a capacity to cultivate collaborative relationships requires a mindset, skills, tools, resources, and practice.  Notwithstanding many large companies' interest in, and commitment to, open innovation, many will be hindered by a transactional, zero-sum mindset.  For many, the collaborative capacity required to facilitate the social interfaces necessary for networked innovation will be slow to emerge.

I suspect that an open network's capacity to generate a sufficient volume of high quality opportunities will be increased to the extent that:

• There are upfront conversations regarding the protocols for engagement that include, but are not limited to, acceptable commercial terms (e.g., royalty rates).
• There is tacit, mutual commitment to equitable returns.

Building collaborative capacity is expensive, so not all relationships can be collaborative.  Many relationships will be transactional/cooperative, some will require asymmetric investment today in anticipation of a collaborative relationship in the future, and some relationships may turn into resource sinks.  (See Everyone is a Customer.)  Nevertheless, in an uncertain world, investing in collaborative capacity may be required to survive, much less thrive.

Confronting Marketing Proliferation

The McKinsey Quarterly interviewed senior marketers from four large companies - Carlsberg, Nokia, Wal-Mart, and Yahoo!  - regarding "proliferating media, customer segments, and distribution channels."  Here is some of what they had to say:

Previously, you could understand a consumer archetype and push information about your brand out to that archetype through, say, three 30-second commercials that would reach 80 percent of adults aged 18 to 49.  Now you must really understand each consumer as an individual.

In other words, the assumption of the representative agent can lead to the fallacy of composition.

We see proliferation on all fronts, with the proliferation of consumer and customer segments in the first instance and the proliferation of media channels as a secondary effect...Now there's polarization between the top and the bottom, and the risk is getting stuck in the middle...It's almost as if beer is in the entertainment...business (emphasis added).

Maybe it's not nuts to consider ways in which Cincinnati may be getting closer to Hollywood.

People are different, so why should we expect them all to want the same product?

Product uniformity favors large scale producers, but relative power has shifted to the consumer.

We carry over 1.2 million SKUs online, as opposed to an average of 130,000 SKUs in stores.  And online, we can also see the things consumers are looking for that we don't carry.  So, whereas we used to see Walmart.com as just another channel, now we see it as a complement to the stores and to the Wal-Mart brand.

It sounds as if Wal-Mart may be mining the long tail for hit products.

We're trying to understand the unconscious mind and the real reasons people buy things...Of course, the products have to be well engineered, and you've got to give people rational reasons to buy something.  But there are very few consumers out there who buy only based on a rational, linear decision process.  Emotional reasons - largely connected to the subconscious - play a critical role.  This is especially true for items or objects that are consumed in the public domain.  In these situations people don't buy just for rational reasons (emphasis added).

In other words, the assumption of the representative agent really falls apart when purchases are socially contingent.  Furthermore, even if we can understand the psychology of socially interdependent decision making, it's not likely that we'll be able to predict the outcomes of such complex behavior.

One issue is that when you're introducing around 50 products a year, and the average life cycle of a product is from 12 to 24 months, you've got a tremendous number of ramp-ups and ramp-downs.  Dealing with that schedule is tricky.

The Red Queen (video) is a demanding taskmistress.

The Disruptive Force of a Global Cascade

Skype is a peer-to-peer network.  When the behavior of nodes in a network is interdependent, the network is subject to global cascades.  From the Skype Heartbeat blog (emphasis added):

On Thursday, 16th August 2007, the Skype peer-to-peer network became unstable and suffered a critical disruption. The disruption was triggered by a massive restart of our users’ computers across the globe within a very short timeframe as they re-booted after receiving a routine set of patches through Windows Update.

The high number of restarts affected Skype’s network resources. This caused a flood of log-in requests, which, combined with the lack of peer-to-peer network resources, prompted a chain reaction that had a critical impact.

Normally Skype’s peer-to-peer network has an inbuilt ability to self-heal, however, this event revealed a previously unseen software bug within the network resource allocation algorithm which prevented the self-healing function from working quickly. Regrettably, as a result of this disruption, Skype was unavailable to the majority of its users for approximately two days.

The folks at Skype have gone out of their way to explain that its service was not a victim to any kind of targeted attack or hack:

We can confirm categorically that no malicious activities were attributed or that our users’ security was not, at any point, at risk.

In fact, peer-to-peer networks are robust in the face of targeted attacks.  Ironically, Skype couldn't protect itself from its own customers.  Once more, the role of the consumer is under-appreciated.  On the one hand, Skype wants its users to use its service constantly.  Furthermore, the company wants its users to be open to automatic updates.  But, as a consequence, Skype contributed to the conditions that make this kind of disruptive cascade possible, even likely.

The Movie Makes the Star

From Hollywood Economics:

The audience makes a movie a hit and no amount of "star power" or marketing hype can alter that.  The real star is the movie.

From CNN:

"Superbad" was super good at the box office, proving that a no-name cast could hold its own amid A-list summer blockbusters.

From screenwriter William Goldman:

Nobody knows anything.

Make the best movies (or products) you are capable of making.  Be humble.  Listen to your audience.  If you are good and lucky, they might make you a star.

Innovation Capitalists & Social Capital

Satish Nambisan and Mohan Sawhney introduce the idea of the innovation capitalist in A Buyer's Guide to the Innovation Bazaar:

It's smart to look outside your organization for sources of innovation.  But the prevailing methods present unattractive trade-offs.  For example, shopping for raw ideas costs less, yet it's riskier and lengthens your time to market.  Shopping for market-ready products (for example, through an acquisition) gets you to market faster, but it's expensive.

What to do?  Nambisan and Sawhney recommend adding a third approach: shopping for market-ready ideas.  This method falls between the two extremes of shopping for raw ideas and market-ready products.  To use it, find an innovation capitalist firm...

Critically, Nambisan and Sawhney  underscore the importance of the relationship between an acquiror or licensor of market-ready products and innovation capitalist firms:

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 [innovation capitalist] firms.

In other words, the ability to access the intermediate range of the "external sourcing continuum" (click on image to enlarge), is predicated upon strong tie relationships.  The purpose of this post is to elaborate upon that proposition.  In my firm's experience, there are, in effect, discontinuities in the uncertainty and value curves perceived by client corporations that are a function of decision-makers' time span of discretion.   As a consequence, the critical resource that expands the window of opportunity for an innovation capitalist firm is a portfolio of personal relationships with very senior decision-makers.

Value is relative, personal, and contextual.  A buyer's ability to ascribe value to an opportunity depends on his effective time span of discretion relative to the perceived degree of development of the opportunity.  Effective time span of discretion is a function of a decision-maker's disposition and situation.  By disposition, I mean a person's mindset and skill set.  To the extent that a person is able to tolerate ambiguity and think in terms of option creation versus operational execution, his potential time span of discretion increases, and he can value opportunities that are "less baked".  Situation is mostly, but probably not exclusively, a function of the decision-maker's position in the organizational hierarchy.  The higher a person's hierarchical rank, the longer his potential time span of discretion.  A person's effective time span of discretion is the lesser of the two potentials.

For example, a far-sighted sales clerk would, nevertheless, have a short effective time span of discretion due to his lack of standing in the hierarchy.  On the other hand, a business unit president who values predictability, efficiency, and execution above all might have a similarly short effective time span of discretion.

All other factors equal, an opportunity that falls within a buyer's effective time span of discretion will be deemed actionable and, thus, more valuable.  An opportunity that falls outside of the time span of discretion will be deemed less valuable.  And, I expect the relative value is discontinuous - more of a step function than the smooth curve depicted at left.  For instance, opportunity A would be deemed much more valuable than opportunity B, even though the difference in uncertainty and time-to-market are modest.  For a buyer having the illustrated time span of discretion, opportunity A is "sufficiently baked" while opportunity B is a "raw idea".

My colleagues have found that a typical effective time span of discretion - even for many senior managers at large corporations - is 12 months.  That is, the time span of discretion seems to be correlated with the budget cycle.  Opportunities that are perceived to lie outside the 12-month window are often indiscriminately labeled "future projects" and, therefore, irrelevant and not highly valued.

On the other hand, the same set of opportunities are likely to be perceived differently by a decision-maker with a longer effective time span of discretion.  If their combination of disposition and situation allows them to take a somewhat longer view, they would be more likely to perceive the value of both opportunity A and opportunity B.  Both would be deemed sufficiently baked and, thus, worthy of consideration.

While a buyer's effective time span of discretion is a key determinant of perceived value, so is the perception of where an opportunity lies on the risk curve.  In the face of the abundant uncertainties surrounding a potential product, value is also a function of the buyer's trust in the work done by the seller - the innovation capitalist.  As Henry Chesbrough has noted, the lack of trust may constitute a rational reason for resisting external ideas:

One such component is the need to manage risk in executing R&D projects, especially when the cycle time to complete a project is accelerating...When cycle times accelerate in a project, there is less time to evaluate and incorporate external technologies...

(Ironically, the Red Queen effect (video) encourages companies to become more open to external sources of prospective innovation while, simultaneously, the related increase in industry clockspeed makes it harder for companies to ascribe value to externally sourced ideas.)

For example, let's say that the degree of development (i.e., uncertainty reduction) asserted by the innovation capitalist is represented by point C in the graph at left.  Absent a strong degree of trust resulting from a shared understanding of mutual competencies, resources, and values, the degree of development perceived by the buyer might be point C_P.  That's because in the absence of trust derived from a strong relationship, the opportunity is likely to be perceived as more uncertain and facing a longer time-to-market.  In other word's the buyer would likely perceive the opportunity as less baked than the seller.  So, even if the seller's assertion of the degree of development is accurate in some objective sense, the perceived opportunity might fall outside of the buyer's effective time span of discretion.  Consequently, the perceived value is likely to be relatively low.

In a previous post, I suggested that pitching raw ideas is a viable strategy to the extent that the ideas complement prospective licensees' existing products, supply chains, and marketing capacities.  At first blush, that assertion appears to contradict the time span of discretion hypothesis.  Nevertheless, I think both can hold true in the context of complementary ideas.

Consider an idea, D_I, that, in isolation, might be considered pretty raw.  That is, there is a great deal of uncertainty regarding the idea's commercial viability as a standalone product.  To the degree the concept truly complements an existing product, manufacturing process, and marketing capacity of a licensee, that same idea could be perceived as being almost market ready, indicated by D_C.

In summary, the value of an opportunity presented to a client company by an innovation capitalist firm is relative, personal, and contextual.  More specifically, a client's ability to perceive value is a function of whether or not the opportunity falls within his or her effective time span of discretion.  Furthermore, the shared perception of the state of development of an opportunity is a function of the degree of trust between the innovation capitalist and the client.  Consequently, the window of opportunity for the innovation capitalist model is likely to be related to the number of deep, personal relationships between the innovation capitalist firm and very senior decision-makers at prospective client companies.

The challenges are numerous:

• Strong tie relationships take time to develop and, therefore, are expensive to cultivate and maintain.
• Relationships tend to run between people rather than organizations.  (Though, over very long periods of time, interpersonal relationships do seem to be able to morph into inter-organizational relationships.)  Furthermore, senior managers' tenure at large organizations is becoming shorter.  Therefore, it is risky to try to develop a relationship with a given client corporation by investing in a relationship with a specific senior manager.
• The range of interest of a given senior manager is still going to be relatively narrow, as it is determined by the range of capacities of his or her organization that exist or can be developed during his or her effective time span of discretion.

It strikes me that a viable approach for an innovation capitalist firm to take is to consciously cultivate a dynamic portfolio of relationships with specific senior managers.  No doubt, it's a very difficult course to pursue, but it offers at least three advantages:

• It expands the window of opportunity for playing a valued role in the intermediate range of the external sourcing continuum.
• A portfolio approach mitigates the inherent risk of individual relationships.
• Because such relationships take time and effort to build and maintain, they serve as a very effective barrier to competition.

Three Product Development & Licensing Strategies

So, you want to license your product?  In order to do so, you'll need to invest in its development in order to transform the "raw idea" into something that is sufficiently "baked".  (Click on image to enlarge.  Adapted from A Buyer's Guide to the Innovation Bazaar by Satish Nambisan and Mohan Sawhney.)  That is, your investment of time and capital will help resolve uncertainty, which will help a prospective licensee perceive value.  Therein lies the trick, because value is relative, personal, and contextual.  Consequently, sufficient development is relative, personal, and contextual.  Furthermore, as one moves from left to right in the development graph, different kinds of capital come into play.  In our experience at Evergreen IP, the interplay of value, sufficient development, and access to different kinds of capital result in three distinct product development and licensing strategies.  Real problems arise when you don't understand which game you are playing, because each follows its own special set of rules.

The first strategy is familiar to individual inventors: pitch the idea.  This strategy draws, primarily, upon human capital, which includes the inventor's ability to perceive and articulate an unmet need, sales skills, and perseverance.  Although some financial capital is required in order to execute basic concept and use tests - as well as to develop intellectual property - the key here is to avoid over-investing.  That's because this approach is likely to work best when the product is highly complementary to a prospective licensee's existing products, supply chain, brand, and marketing channels.  In other words, a raw idea is more likely to be perceived as having some value, if it represents an incremental improvement.  However, "some value" usually doesn't translate into very much, so it's wise to keep your investment as low as possible.

The advantages of this approach include the following:

• It doesn't cost much to play.
• Deep relationships with prospective licensees help, but aren't required, which opens up the range of prospective licensees you can approach.
• It doesn't take that much time, relatively speaking.  So, even if the hit rate is low, you'll have the ability to take more shots over time, which means you can benefit from a dynamic portfolio of opportunities.  Think of it as the savings approach versus the lottery approach to wealth.

That said, most individual inventors don't have the sales skills, discipline, or perseverance to win at this game.  People who tell you this is easy are scamming you.

Running the market experiment used to be the sole domain of companies.  That's no longer true.  Direct response marketing techniques, affordable e-commerce, and outsourced manufacturing and fulfillment options mean that individuals and tiny companies can find out whether they have a market-ready product by actually putting the product in the market.  The nuance here is to use the market experiment to resolve uncertainty in order to license or sell the product to a larger company as quickly as possible.  After all, large companies have one clear experiential advantage over the rest of us - they know about scale.  Scaling is a lot harder than first time entrepreneurs can understand.  On the other hand, big companies don't have a particular advantage when it comes to introducing new products - particularly differentiated products - to the market.  They may even be disadvantaged.  So, there is value to create and earn by running the market experiment yourself.

Of course, this strategy requires a relatively high amount of financial capital.  An on-line launch may take six figures and a DRTV launch may require six or seven figures.  Consequently, the risk is much greater, though the potential rewards are higher, too.

• Although easier today than ever, launching a product requires a much deeper and broader pool of human capital.  Partner with people who know what they are doing.  Don't sandpaper your collaborators by being greedy - you'll need them again.
• Even if you do an outstanding job with a terrific product, your chances of success are probably no better than 50%.  (See my other postings about the critical role of the consumer in the innovation process.)  Consequently, plan on raising enough money to launch three of four equally terrific products in order to have a good chance of overall success.
• An exit from this kind of investment falls squarely into the familiar realm of M&A, so deep relationships with prospective acquirors are not necessary.  Recognize, however, that it's tough to value a product in its infancy.  Acquirors are prone to gross under- or over-valuation.  Hope for the latter, but plan for the former.

The third path is the intermediate case, what Professors Nambisan and Sawhney call the innovation capitalist strategy.  It is the take 'n' bake approach to innovation: the innovation capitalists invests substantial capital and time in order to resolve a significant amount of uncertainty, but the product is not taken all the way to market.  As the editors of Harvard Business Review summarized, "Innovation capitalists reduce [the risk faced by licensees] by spending their money to develop a promising idea.  And they help you avoid the up-front costs of acquiring fully baked products."  In turn, the innovation capitalist counts on getting a commensurate return on investment - something higher than one might expect for a less well-baked idea, but less than one might expect for a product that has been demonstrated to be market-ready.

To be successful, aspiring innovation capitalists need access to human capital and financial capital.  But, the critical resource may well be social capital - long-term, trusting relationships with quite senior decision-makers at large organizations.  There aren't likely to be too many successful innovation capitalists for at least two reasons:

• Most people won't really understand the importance and nature of these critical relationships.
• It takes time and effort to cultivate a sufficient portfolio of such relationships, which makes social capital relatively rare and expensive.

I'll explain my rationale in a subsequent post.

Strategic clarity is liberating.  Be honest with yourself regarding your access to human, social, and financial capital.  If you don't have access to millions of dollars, and if you don't have established relationships with a portfolio of the heads of business units or corporate vice presidents at large companies, you'll need to rely on your personal sales skills and perseverance to successfully license your idea.  Don't over-invest; don't put yourself in the position of having to hit a home run, because the odds are exceedingly long that you'll strike out.  And, if you do get a hit, it's very likely to be a single.  Take it, and then swing at the next good pitch that comes your way.

Rethinking the Nature of Real Estate Risk

Today, The Economist wrote the following about the market turmoil attributed to mortgage backed securities and related derivatives:

The people at Goldman Sachs lost a packet when something happened that their computers told them should occur only once every 100 millenia.

Oops...I guess Goldman's models were wrong.  But, I wonder whether many of us have similarly misunderstood the changing nature of risk - maybe particularly as it relates to the kind of volatility we're likely to face in the real estate markets.  In other words, though I've little doubt that loose credit has exacerbated the problem, I imagine that the source of real estate volatility is intrinsic and different in kind rather than just degree.

Let me explain by telling a tale of two (small) cities: Bozeman and Butte, Montana.  Butte is a mining town.  In 2005, the median household income there was $33,300, and the median home price was just $79,800.  Bozeman, on the other hand, has morphed from the agriculturally oriented home of the state's land grant college into "Boze-angeles," a place where lifestyle, second homes, and a nascent technology community shape the community.  Bozeman's median household income in 2005 was $38,800, but its median home price was $208,300 and climbing.

Why the disparity in real estate values?

I imagine that the intrinsic value of real estate has to be a function of its economic productivity.  Historically, the productivity of land was a function of what you could extract from it in the form of minerals, timber, and crops.  Later, economic productivity of land was a function of what you could manufacture upon it.  In short, productivity was a function of the physical world, the variability of which is often best described in terms of the normal curve.  Consequently, the intrinsic variability in real estate value might have been similarly described by a normal curve.

However, the economic importance of the physical world has diminished in relative terms.  The information based economy is ascendant, and real estate values in Silicon Valley, Boston, and, indeed, Bozeman, have increased, while those in Detroit and Butte have been relatively stagnant.  Information economies  - whether derived from high technology, fashion, lifestyle, or financial products - seem to be a core source of the increase in real estate value in a growing number of places.

Note, though, the volatility of information - and the risk in derivative real estate values - seems quite different than the volatility of the tangible.  Information economies appear to be dominated by power laws, while the familiar normal curve - the distribution embedded in Goldman Sach's computer models - is applicable to the economy of the tangible.

I strongly suspect that's true because social contingency plays a greater role in economies characterized by greater degrees of information content.  Think about the social psychology of the iPod, for example.  Where there is social contingency, information cascades are likely.  Where there are information cascades, there are power laws.  Where there are power laws, the "once in a hundred millenia" chance becomes commonplace - for better and worse.

Home owners in Butte may, relatively speaking, be playing by the old rules of investment volatility.  Home owners in Bozeman, on the other hand, may be making investments that have much, much greater volatility.  Although the long term trend in values are likely to favor Bozeman's information-derived economy, the home owners in my hamlet may face a wild ride.

Anyone up for an investment in a highly leveraged piece of real estate with a floating rate of interest?

Design It Before You Buy It

The Wall Street Journal reports (subscription required) on an online 3-D tool that lets consumers tinker with a product during the design stage:

3dswym - which stands for 3-D See What You Mean - creates a three-dimensional image of a particular product that is still in the design stage.  Then it allows people to go online, spin the product around, alter it and place it in different contexts, such as on a supermarket shelf or in a kitchen cabinet.  If consumers don't like what the company has proposed, they can change it as many times as they like.  The information is then fed back to the company designing the product...

Publicis estimates that companies that use the product can shave about one-third off the time it takes to bring a packaged good to market.  By using a virtual image they can avoid having to create physical samples of the item, gather a focus group and then try it out in a test supermarket.

It strikes me that such a tool could be valuable in at least a couple of ways:

• Given a choice, I prefer to be able to get input from prospective customers.
• With the Red Queen lurking, getting products to market faster is a necessity.

But, I'm skeptical:

• Although the appearance of a product is likely to influence trial by consumers, perceptions of performance help drive repurchase rates.  With packaged goods, repurchase matters a lot.
• The interpretation of input from focus groups of any kind often rests upon the assumption of the representative agent which can lead to the fallacy of composition.

In other words, I suspect that tools such as 3dswym might turn out to help get better products to a test supermarket faster, but I doubt that such tools will prove an effective substitute for running the market experiment.