“Innovation networks” and the size of the pie

It’s becoming a bit of a corporate buzzword – “innovation networks” – but one that (to my slight disappointment) I actually quite believe in.

More and more companies I see and talk to seem to realise that it is quite difficult to be innovative on your own. For true innovation, almost by definition, you need a wide variety of capabilities, knowledge and insights. It is just difficult to find such diversity within one organisation. If you, as a firm, are trying to come up with fundamentally new things, you would likely do well to also look outside your own organisation’s boundaries, whether anyone knows anything that just might be useful and interesting for you.

This is what “innovation networks” are about; combining and tapping into other companies’ knowledge resources to, collectively, come up with something that neither firm could have done by itself.

IBM, for example, does it consistently and in a highly structured way. They work with specific partners on specific projects. Some of these partners are from outside their industry but others could even concern straight competitors. For example, in their Cell Chip project, developing multi-media processors, they work with Sony, Toshiba and Albany Nanotech. In their Foundry R&D project, designing manufacturing processes for mobile phone chips, they work with Chartered, Infineon, Samsung, Freescale and STMicroelectronics. And they have several other similar projects, with yet different groups of partnerships.

However, the networks can also be of a more informal nature. For example, the successful Sadler’s Wells theatre in London, which focuses on the creation of ground-breaking modern dance, has no orchestra or ballet of its own. Instead, it tries to create innovative modern dance shows by putting artists in touch with each other who otherwise would not have worked together. They organise dinners during which those artists meet, they give them some studio time and budget to improvise and experiment, and assist them with advice and other facilities to get them to combine their skills and talents to create new forms of modern dance. What they ask in return is that the artists premiere their performance in Sadler’s Wells.

The most striking example of informal innovation networks I have seen, however, is that of Hornby; the iconic English producer of little model trains and Scalextric slot car racing tracks. They have some more or less formal alliances with software producers and digital electronics companies, which for instance led them to develop virtual reality train systems and digital slot car racing tracks (allowing multiple cars in lanes, which can overtake each other; clearly the most prevalent schoolboy dream since the emergence of Samantha Fox!). Yet, they also have some striking informal networks, which stimulated their innovativeness.

For example, one of their latest innovations is a real steam train (which retails at a whopping £350), and I mean real steam. The little whistler doesn’t run on electricity but on actual steam. The interesting thing is how they came up with it. Well, or actually, they didn’t… One of their customers did. They maintain close networks – on-line, by organising collector clubs, tournaments, etc. – with their collectors. Through these networks, they learned about a hobbyist who had invented a real model steam train. They went to visit him and adopted his rudimentary technology.

But the most striking example of their informal innovation networks I saw when I visited Frank Martin, Hornby’s CEO, at the company in Margate some time ago. In his office lay a piece of slot car racing track. “Look” he said “a very innovative and sophisticated new surface, which is not only much more realistic but also much less slippery for the toy cars. Our Spanish competitor sent it to us”. I said “what?! why would your competitor do that? are you sure it is not a fluke? are you paying them for it?” And he replied “no, whenever they invent something new, they send it to us. And we also send them stuff”.

They have no contracts or any other formal arrangements in place for these exchanges. They just figure, ‘we could shield our innovations from our competitors but we’re all much better off if we share them’. The size of the pie (the total size of the market) will increase as a result of it, and they all benefit; much more than when they would all keep their innovations to themselves.

It is a peculiar type of innovation network, if your customers and even competitors become part of it and share their innovations with you, purely on the basis of trust and reciprocity, but it is certainly a formula that works for Hornby. They managed to quintuple (I had to look up this word) their stock price over the past few years, partly as a result of such innovations. Innovation is important to many companies in many businesses; too important to (merely) leave to your own devices.

Boardroom friends

Boards of directors, in various countries and systems, lately have been subject to considerable frowning, loathing, smirking and indecent hand gestures. “They’re all part of the same elite”, “corporate amateurs”, “never really objective”, “not really independent”, “an old-boys-network”, etc. etc. Surely, it is said, those directors that are pretty much personal friends of the CEO will be quite useless; they will just protect him and never really be critical, asking the nasty and awkward questions they should be raising.

Yet, is this necessarily so? Are “friends” bad directors? Professor James Westphal, of the University of Michigan, became sceptical of the sceptics. He investigated whether social relations between board members and CEOs really are as harmful as assumed. He extensively surveyed 243 CEOs and 564 of their outside directors and examined whether personal friendships and acquaintances made for less effective board members.

First of all, he found that the boardroom friends hardly ever engaged in less “monitoring” of the CEO (that is, checking strategic decisions, formal performance evaluation, etc.) – the traditional stuff that directors are supposed to do. They were still quite active in that sense, despite being the CEOs personal friend.

In addition, Jim found that boardroom friends engaged a lot in another type of behaviour towards the CEO: ongoing advice and counselling. They gave their CEO informal feedback about the formulation of the firm’s strategy: they acted as a ‘sounding board’, continuously provided general feedback and suggestions, etc. All this happened outside the company’s formal board meetings. Directors who were not personal friends hardly engaged in this type of behaviour.

Usually CEOs don’t easily do this; accept or even ask for ongoing counselling and opinion. It is well-known from research that a primary inhibitor to seeking advice is the perceived effect it could have on the advice seeker’s status. People often believe that others will view their need for assistance as an admission of uncertainty or dependency and as an indication that they are less than fully competent or self-reliant.

Little doubt that CEOs – who are expected to be confident, proud and self-assured – have these tendencies too! Fierce, testosterone-driven CEOs may not take criticism or even advice easily, but if the director is a personal friend, it might just be a bit easier to swallow. Psychologically, it is just a bit more secure to listen to criticism from someone you know and trust than from a formal stranger. Hence, having your friends in the boardroom may not be such a bad thing after all.

Eating uncle Ed – don’t worry, it’s called downsizing

About a century ago, the Fore people, who inhabited Papua New Guinea, had the habit of burying their deceased relatives, just like many other societies. Yet, on some sunny day, Uncle Ed died, and it was just around lunch time. Uncle Ed’s relatives were about to put him into the ground when one of his cousins (who looked particularly hungry) said “why bury all that good meat; it’s a waste; we might as well eat it”. And so they did.

When the following month another relative died, they did the same thing, and not for long, the whole village was eating their deceased relatives, rather than putting them into the ground. The advantages were obvious; there had actually been quite a bit of famine and malnutrition among the Fore people and this habit enabled them simply to not be so hungry.

Some time later, a visitor from a neighbouring village witnessed the practice. When he got home and his cousin died, he quickly convinced his relatives to rather than bury the good chap, consume him on the spot. Gradually the practice started spreading to all villages in the tribe, until the habit of eating deceased relatives had become the norm and the Fore’s proud tradition.

Yet, unfortunately, they ate everything, including their relatives’ brains. As a consequence, they developed a horrible, lethal disease called Kuru (which is related to Creutzfeld-Jacob, aka mad cow disease). The disease has quite a long incubation time (i.e. it takes several years before it becomes apparent) but eventually the Fore people started getting sick and dying in masses. Of course, they noticed something was seriously wrong but, due to the disease’s long incubation time, had no idea that their misery was caused by the habit of eating their deceased. The practice continued until half of the Fore population had been wiped out and Australian invaders put an end to it (because they thought it was gross, not because they understood it caused the disease).

Why am I telling you this story – after all, you might be reading this just before lunch? The reason is as follows: Many managers and companies remind me of the Fore people.

Let me explain: The Fore’s practice clearly was detrimental; after all, it was killing them! Yet, the reason for them adopting it was clear too: the practice gave them an immediate advantage, namely less hunger and less starvation. In the long run, however, they were definitely worse off for doing it but the problem was that, due to the practice’s incubation time, they could not understand that it was this habit that they had picked up many years ago that was causing the problems.

Quite a few popular management practices have the same characteristics. The problems they cause only occur in the long run and are therefore underestimated or not understood at all. The benefits are immediate.

Take, for example, the practice of “downsizing” (or rationalizing, restructuring, reorganising, etc.: that is, making people redundant). It is a trend that has now been going on for at least a decade and a half; companies – even if they are not in financial difficulties – engage in systematic programmes to reduce the headcount in their organisations. The short-term benefits are clear: It leads to lower costs (sometimes accompanied by a positive response from the stock market to the announcement of the programme). Yet, there is also evidence of sizeable long-term detrimental influences, such as reduced innovation and lower employee commitment and loyalty. However, such consequences are only noticeable in the long run.

Usually, when a firm faces a serious problem, for example due to a lack of new products in the pipeline, top management does not realise that the lack of innovation is caused by the downsizing programme that they engaged in a near decade ago. Just as it did for the Fore people and their illness, the long lead time makes it all but impossible for managers to connect and understand cause and effect. Thus, not only will top management take inappropriate action to solve the problem (not seldom another cost-cutting programme…), it also remains unclear to other firms that downsizing is harmful, leading them to adopt and continue the practice too.

“A serial changer”…

Some time ago, I interviewed a guy called Al West. And Al is quite a guy. Not only because he is the founder and CEO of SEI, an investment services firm headquartered in Oaks, Pennsylvania, which is worth about 4 billion (of which he still owns about a quarter) but because of the way he runs his company.

For example, I asked for the contact details of his secretary to put an appointment in the diary. He doesn’t have a secretary. Actually, he doesn’t even have an office. And when I went to their London office to speak to him, reported at reception and asked for Al West, the lady behind the desk said “Who? Al West you say? Let me see if we have anyone in this company by that name”. Al doesn’t strike me as the stereotypical autocratic, macho CEO.

What Al does strike me as – and which is the reason why I wanted to talk to him – is a “serial changer”; or at least that is how one of his employees described him to me. He is altering his organisation – in terms of its structure, incentive systems, decision-making procedures, etc. – all the time, never quite satisfied and never quite done. And somehow, I suspect that is part of the key to his company’s success.

In 1990, Al broke his leg in a skiing accident. He lay in the hospital staring at the ceiling for about 3 months. When he came back to work, despite the company growing and performing well, the first thing he did was completely reorganise the entire firm. His employees thought, “why change a winning formula? he must have been quite bored and couldn’t think of anything better to do. I am sure it will pass”. But it didn’t pass. Ever since, Al has been reorganising his company regularly.

And he does it because he doesn’t want to allow his organisation to become settled and “comfortable”. SEI has been growing steadily for decades now, with an impressive – and impressively stable – 30% per year. Yet, Al never does any acquisitions (he feels they would disrupt the smoothly-running organisation). Yet, unlike many other successful companies, SEI doesn’t get trapped in its own success and gradually grow rigid and inert. SEI continues to innovate and grow.

The reason why many very successful companies find themselves in trouble in the long run, is that they become too insular, narrow and set in their ways. This leads to problems when their environment changes. Yet, Al’s regular changes to his organisation prevent it from becoming set in its ways. Moreover, powerful people and groups within an organisation usually, over time, become even more powerful (because they can get their hands on even more resources, budget and people); too powerful for the good of the firm. Yet, in SEI people don’t get a chance to create fiefdoms and accumulate influence beyond what’s good for the company. Al doesn’t give them the time to do it.

Along similar lines, my colleagues Phanish Puranam and Ranjay Gulati examined periodic structural changes within Cisco. And they found that Cisco’s many reorganisations helped to solve some tricky coordination problems within the firm. In many organisations, over time, employees become focused on their own unit, group or department. It’s their perspective that they view things from, that’s where there social networks lie and whose interests they pursue. By regularly reshuffling departments, however, Cisco's people not only are forced to develop new perspectives and cooperate with other people, the contacts and perspective of their old group (now dispersed across the firm) are still available too, so that the firm gets the best of both worlds. Professors Nickerson and Zenger found similar patterns examining Hewlett Packard’s regular switches between centralisation and decentralisation.

The regular changes to the organisation prevent it from becoming rigid and inert. They may be perceived by people working in the firm as a pain (in all sorts of body parts) if not completely unwarranted (“we’re performing well, aren’t we? why would we change anything?") but it helps avoid more serious trouble in the long run.

Say you will – that’ll do

How to reward CEOs and other top executives is an ongoing area of discussion and research. Often it is claimed, of course, that executive compensation should be closely tied to the performance of the firm (but that stock options – an often-used way of rewarding executives – are quite imperfect, for instance because they can be exercised over an extended time regardless of performance).

Yet, it is not easy to measure “the performance of the firm”. Performance in terms of what? And performance over what period? Therefore, a decade or two ago, the use of so-called “long term incentive plans” came about; simply put, top executives receive rewards (in the form of stock or cash) on specific dates dependent on whether specific performance goals are met. Such incentive plans are thought to much more precisely link rewards to managerial performance, encouraging executives to direct their attention to long-term profitability rather than short-term gains.

The stock market (that is, investors and analysts) loves them. Ample studies in financial economics show that when firms announce the adoption of long-term incentive plans (for example through press releases or proxy statements), their stock price immediately shoots up. Managers may not always like them – getting rewarded (or not) based on very specific targets at very specific points in time sort of spoils the fun a bit – but it was also hard to resist them; not adopting one of those thingies made you look “illegitimate”. Hence, the top managers of many firms decided to adopt them after all.

Professors James Westphal and Ed Zajac decided to study the stock market effects of these long-term incentives plans once again, but they did something more. First, as expected, examining 408 large US companies, they too found that adopting firms’ share prices went up immediately when they announced that they were going to install such an incentive plan.

Yet, then Jim and Ed also examined whether it mattered how you worded the announcement statement. Specifically, they measured whether the firm's justification for adopting the incentive plan explained that it did so to tie CEO compensation more closely to shareholder wealth (that is, “all the right reasons” for investors; for instance Alcoa did this), instead of a more general description, for instance some sort of HR description (“this plan enhances our ability to attract talent”; AT&T) or no explanation at all. And they found that upon announcement, the stock price of the firms “who used all the right words” went up with 2.4%, while the stock price of the other firms announcing the same plan (but using some other type of explanation) only increased with half of that (1.2%). That is, double benefits from the same thing, by only choosing your words a bit more carefully! That’s easy money.

Then though, it got really interesting. Next, Jim and Ed examined what happened to the stock price of the firms that announced that they were going to adopt a long-term incentive plan but, subsequently, did not actually do it… (a whopping 52% of firms did this!).

This is what they found: First, they found that the stock price of those firms went up on announcement of the plan just like it did for the others (and why not, the stock market could not yet know they were not actually going to implement it!). Then Jim and Ed measured what happened to the stock prices the week following the announcement (when they still had not actually adopted the scheme): nothing; stock price was still up. Then they measured what had happened after a month; stock price still up… Then they measured the outcome after a full year; stock price still up…!

Stock prices went up after announcing the incentive plan. Stock prices did not go down even when the firm subsequently did not actually implement the scheme! Speaking about easy money!!

Is the stock market stupid, or what?! Well… perhaps the answer partly is ‘yes’… but it is probably also a bit more subtle than that. Apparently you and I, investors and analysts, care about firms using the right language but we care much less about what they actually do. Hence, we reward their symbolic behaviour, rather than their real actions. We may not even be fully aware of it but that’s what we value: unlike Caesar's wife Pompeia (who, according to Caesar, not only had to be virtuous but also appear virtuous), we want a firm to appear virtuous; yet we don't care whether she really is!

Pharma – the devil is in the detailing

What do you think pharmaceutical companies spend most of their money on? R&D: the search for new drugs? Think again.

True, pharma companies spend a great deal on R&D; studies show it comprises about 14% of their revenues. Yet, they spend about 1/3 of their revenues on Marketing. That’s right, on average, pharmaceutical companies spend two to three times as much on the Marketing of a drug as on its development. (Hence, next time you hear a pharma executive claim they need to charge such a high price for drugs because of the high costs of R&D, do frown at him fiercely!)

By far the largest chunk of these marketing expenses are taken up by the practice of “detailing”; that is, a vast army of company representatives visit physicians to shower them with information, free samples, and persuasive arguments (and a “healthy dose” of free gifts and travel), claiming that the company’s drug is wonderful and really does what it says on the tin. The raison d’etre of this practice is that physicians – human as they (often) are – only remember and hence only prescribe a limited number of drugs; much fewer than are in existence. Therefore it is important for a pharma company to make sure that physicians know their drugs; they’ll hammer them into their brains (with brute force if necessary!).

Moreover, over the last decade or so, the army of representatives has been expanding with particular vigour. For example, in the US alone, between 1996 and 2000, the herd of quacks with their suitcases full of pills and ointments rose from an already impressive 41,800 to a fearsome 83,000 pharma-suits.

Yet, is this practice of “detailing” really effective? Mwa…(at best).

Research has shown, for example, that on average it takes 3 visits to induce one new prescription. It also takes an average of 26 additional free samples to generate one additional prescription. Hardly impressive I’d say.

Then why do most pharmaceutical companies continue to rely on detailing? Well, there are also studies – mostly internal research by the pharma companies themselves – that do not provide unambiguous evidence that detailing does not work. Hence, they’re just not 100% sure that it is an outdated practice. They fear there is a risk that if they stop using the practice they will lose money. And that’s a risk they’re not willing to take.

“But”, you might add “they’re currently also at risk of losing money because they are continuing the practice”. And of course you’d be right. However, we know from research – for example on variations of “prospect theory”, by Nobel Prize winners Kahneman and Tversky – that people are often a lot more comfortable with the risk of losing money when everybody else is making the same mistake than with the risk of losing money when they’d be the odd one out (even if the latter amount is considerably less than the former).

For example, if a company were to stop detailing but it turned out they were wrong and they’d lose market share and money as a result of it, we (the public) would say “you’re stupid (nobody else did it)”. Currently, firms might be losing (a lot more) money because they continue detailing but now none of us say they’re stupid; because everybody is still doing it and we’re just not sure that the practice is not effective. Hence, the risk of breaking the mould is perceived to be much higher than an undue acceptance of the status quo.

It is a situation very similar to that of the newspaper companies who were reluctant to switch to a tabloid-size format 5-10 years ago: they were just not sure that small size newspapers would catch on. Hence, while everybody was printing broadsheet, nobody dared take the plunge and make the paper smaller.

It takes someone to break the mould and show the way. Usually, that is an outside entrant or a firm in financial distress (who just had to take a risk) – just like the Independent was in financial distress when they were the first to launch a small-size newspaper. Since those scenarios (outside entrants; financial distress) are rather unlikely in the world of pharma with its large entry barriers and deep pockets, detailing may just be with us for quite a bit longer.

Means & ends; profits & innovation

Don’t ask why, but I have long been interested in what makes certain companies better at innovation than others. Research shows that it is actually not that easy to remain innovative. Once a firm becomes profitable, over time, it is as if the organisation loses the urge to be really innovative and creative, and come up with truly new products and services.

Therefore, one of the things I always ask the executives of a company whose innovation process I am examining is “why do you want to be innovative?” Invariably, the answer is that they realise they need to innovate in order to remain profitable in the long run.

And this is a good point. You may be profitable now, but if you wait to invest in innovation till you see your performance dropping – trying to innovate yourself out of the looming trouble – it may be too late. True innovation has a long lead time; only starting to think about new stuff once your old stuff is beginning to show signs of decay often means you have left it too late. Moreover, by then, you may be out of touch; once you really stop innovating it will be very difficult to get back into it.

All this is of course not rocket-science. Yet, over the past year or so, I have been examining a rather different but also consistently very innovative organisation – as a matter of fact, one of the most innovative organisations of its kind it the world: the famous Sadler's Wells theatre in London.

Sadler’s Wells is a large theatre (their main auditorium takes about 1900 people) which is focused on modern dance. And they host and (co)produce some of the most innovative productions in the world. Moreover, they manage to consistently attract large audiences and are – which is quite rare for such a theatre – financially self-sufficient, very healthy and sound.


When I was talking to their managing director (Chrissy Sharp) and chief executive (Alistair Spalding) – about their many productions, how they organise them, the relations between the theatre and the artists, etc. – at some point I also asked them my usual question: “why do you want to be innovative?” They both stared at me in silent disbelief…

While I was pondering whether they might be wondering whether I was serious (or mad), thinking it was just an incredulously stupid question, or considering to stop the interview immediately, Chrissy finally stammered “but… because we have to… it is what we do”.

Then it dawned on me, they had never even considered the question before.

And gradually, speaking to many more people in the organisation, I figured out that there is a subtle yet fundamental difference between Sadler’s Wells’s commitment to innovation and that of many of the businesses I’ve seen. Companies invariably see innovation as a means to an end; you have to innovate in order to remain profitable. Sadler’s Wells theatre views it the other way around; you have to make a healthy profit in order to be able to continue to innovate.

For them, profit is the means and innovation the end. Companies often struggle to remain truly innovative when they are making huge profits; the urge and feeling of necessity just inevitably slips away. Not for Sadler’s Wells; they continue to innovate, and innovate a bit more the more profit they make. It is not the big, tried-and-tested projects that they have been running for years that excite them, but the new, risky, creative productions that no-one in the world has seen before that get their hearts racing. They respect their established projects but invariably use the profit they make through those to invent new stuff.

And I wonder whether not more companies should adopt this stance: where the organisation’s ultimate commitment is to innovation. It is good to make a profit, and ever better to make a lot of profit. But innovation is what keeps you healthy in the long run, and what generally tends to excite your people; employees and customers alike.

Not all trouble is trouble

True story: Some time ago I was talking to a CEO regarding an acquisition his company had just done. The topic of “integration trouble” came up, and he said, “I’ve figured out how to avoid all such trouble; I just always quickly and completely assimilate the whole thing”. And indeed, after acquiring the company he immediately merged it with the rest of the firm, spreading out all the new people across different departments and offices.

Around the same time, I was talking to an executive (in charge of M&A) at another company, regarding “integration trouble”. He said, “I’ve figured out how to avoid all such trouble; you simply have to leave them alone, and not meddle in”. And that was what he did with his acquisitions; he bought them but subsequently left them completely autonomous in all aspects of the business.

But who is right, and who is wrong? Hey, I am feeling in a positive mood: I am sure they’re both right. Well… and both wrong…

Both strategies, indeed, usually manage to avoid severe integration tensions. Yet, they also prevent value creation. In order to create extra value, beyond the original two companies’ worth, some form of integration will have to take place; otherwise you’re just owning the two companies like any shareholder owns stock (you just bought it at a high price). Similarly, completely assimilating both units will destroy any potential for value creation, since you’re eliminating all differences between the companies, and just increasing the scale of an organization will seldom result in extra value. The differences are the source of potential value.

When Novartis, for example, was created out of the merger of Ciby-Geigy and Sandoz, subsequent CEO Daniel Vasella explicitly set up an integration program to create a new organization, which in many respects was entirely different from anything either of the companies had before. This approach doubled the company’s value in about a year. Similarly, Igor Landau, former Chairman of the merged pharmaceutical firm Aventis, said, “The strategy was to create a new company and not be the sum of the two previous companies. We decided either we create something new or we would pay the price down the line”.

Acquisitions can be useful, but often only if they are utilised to create something new, that the companies could not have done by themselves. Thus, it is tempting to avoid (integration) trouble, by either quickly and entirely assimilating an acquired unit or leaving it completely autonomous. But sometimes you have to bite the bullet; integration troubles can also be the symptoms of a much more healthy process, of organisational revitalisation and the creation of new value.