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Deep Innovation: The Well-Oiled and the Cantankerous

August 2004 Corporate, Product

What factor drives innovation into large companies versus entrepreneurial firms? Should firms fund deep innovation within or should innovation be driven through acquisitions? Should entrepreneurs expect swift competition from goliaths or a few years of solitude while they develop their market?

To a casual business observer, it may appear that innovation and new product development occur everywhere continually, but this is misleading. Most research and development investments deliver incremental product improvements that enable companies to better serve their current market. Deep innovations, the kind that produce entirely new customer solutions and industries, are in fact quite rare. It is this deep innovation that produces entirely new solutions to customer challenges and subsequently creates new markets and revenue growth.

Whether deep innovation is delivered through entrepreneurship or corporate research and development projects is not just an academic question. The understanding of deep innovation and where it will occur influences business, investment, and venture capital strategies. The difference between inside innovation and outside innovation appears through the choices of executives in established businesses when they trade-off spending $10 M in acquisitions versus $10 M on internal R&D. Likewise, the difference between corporate and entrepreneurial innovation drives employment patterns and investment choices.

Exit plans for entrepreneurial firms often include the possibility of being acquired by a larger firm. Large corporations often establish Mergers and Acquisitions departments to scour the landscape for promising new opportunities while maintaining a large R&D division. Likewise, investors and venture capitalist are continually hunting for the next big thing while, at the same time, demanding growth from more established corporations. Should deep innovation be nurtured within larger firms or be harvested from entrepreneurs?

This article seeks to develop an understanding of one factor that drives deep innovation into large corporations in some industries while entrepreneurial firms lead in others. To develop this understanding, we first examine held beliefs about deep innovation from authors and corporations, then posit that a major factor that drives deep innovation into large corporations rather than entrepreneurs lies in the barriers to customers.

Corporations vs. Entrepreneurial Firms

Large corporations are capable of deep innovation.

  • Lou Lehr, a past CEO of 3M, increased R&D investments and productivity to the point that in 1985, 25% of their revenue was derived from new products introduced within the previous 5 years. 3M’s business strategy was supported by numerous internal rewards and opportunities for employees to explore new ideas and develop potential products.(1)
  • Pharmaceutical companies like Merk are known for their ability to develop new formularies within their research and development labs. The science of managing R&D at pharmaceutical companies has progressed to the point that real options analysis is a required skill within their finance departments.(2)
  • Much of the innovations in silicon that enable Moore’s Law to be achieved year after year are produced by major corporations like TI, Intel, IBM, and others.
  • If we examine the development of the CD, we find the corporate giant Philips to be the champion in marketing this technology despite the numerous competitors and researchers that participated in its development.

From these examples, it is clear that a large number of corporations in a variety of industries are able to produce deep innovations. Yet, their hold on deep innovation is not exclusive. Entrepreneurial firms continually enter industries with ideas that are outside of the mainstream and yet successfully penetrate established markets.

For instance, within the software industry, small firms have delivered far more deep innovation than larger ones. As The Economist noted, “Microsoft has one of the largest research budgets in the world… . But it also has one of the worst records when it comes to the efficiency of its research dollars – ie, its actual records in innovation. Its success has overwhelmingly been due to developing copy-cat technologies and paying top dollar to buy promising small firms.”(3) And Microsoft is not alone. Sungard grew to become one of the larger companies in financial management software through its acquisition strategy not its research and development. Likewise, SPL’s recent decision to acquire rather than develop new software for the utilities vertical rested in the ability of others to develop software outside of its core knowledge domain.

The ability of others to develop new ideas has led many industry analysts to suggest that funding deep innovation within large corporations may be a misuse of funds. For instance, Hamel & Getz stated in a recent HBR article: “Regardless of how creative your employees may be, there’s more innovation potential outside of your company than within it.” (4) Even Geoffrey Moore relegates deep product innovation to the early stages of a market and suggests that organizations focus on other forms of innovation when serving maturing, mature, and declining markets. (5)

These opposing cases and viewpoints drive the question: Should innovation be pursued within large corporations or should it be left to the entrepreneurial firms?

Barriers to Customers

If we focus our attention on the differences between the industries wherein deep innovation is delivered by large corporations versus those industries wherein deep innovation is delivered by entrepreneurial firms, we can find that a key factor that drives the source of deep innovation is customer access. Access to customers, both for initial sales and marketing and for translating idea generation into customer applications, is a key factor.

If we return to the case of pharmaceutical innovation, we quickly uncover a customer access barrier in the form of the FDA approval process. We can find a few entrepreneurs searching for new formularies but their business development plan will call for the licensing of their formulary to an established pharmaceutical firm if not the outright sale of their company. In the past, entrepreneurial companies in pharmaceuticals rarely intended to develop their formularies, enter the market, and rival the established giants. Entrepreneurs in pharmaceuticals avoid outright market development largely due to the challenges of receiving FDA approval for their formularies. The FDA approval process took an average of 7 years to complete with numerous stages of trial. Few venture capitalists are willing to fund an unproven company with such high exit barriers.

Likewise, the funding of deep innovations in hardware requires the ability to reach customers. In the Philips CD example, we find that the barriers to customer access arrived in the form of industry coordination challenges. The sales of CD’s and CD players needed the participation of music labels, CD manufacturers, and competing CD player producers. Philips addressed this coordination through a number of negotiations with each industry cohort. A smaller entrepreneurial firm would not have had the strength and bargaining latitude to undertake these complex negotiations.

In contrast, new ideas in software face relatively fewer barriers to customer access when initiating sales and marketing. Achieving the first few cornerstone customers is never easy for entrepreneurial firms, but software entrepreneurs with new solutions to customer challenges rarely face the challenges similar to the FDA approval process or industry coordination. Once a few cornerstone clients have been captured and retained, corporate concerns can shift from development toward ramping up the sales and marketing effort, either internally or through being acquired.

Deep Innovation guided by Customer Access

Customer access is not the only determinant with regards to driving deep innovation. Other factors such as corporate culture, innovative genius, competitive evolution, and funding clearly influence the path of deep innovation. Yet customer access is clearly a large determinant factor in choosing between nurturing innovation within the well-oiled machines of corporations and harvesting innovation from cantankerous entrepreneurs.

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References

1. “3M: Profile of an Innovating Company”, Harvard Business School, 1995.
2. Timothy A. Luehrman, “Investment Opportunities as Real Options: Getting Started on the Numbers”, HBR, July-August 1998.
3. “An End to Growth”, The Economist, July 24, 2004.
4. Gary Hamel & Gary Getz, “Funding Growth in an Age of Austerity”, HBR, July-August 2004.
5. Geoffrey A. Moore, “Darwin and the Demon: Innovating within Established Enterprises”, HBR, July-August 2004.



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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