Discovery Driven Strategy TechColumbus Innovation Summit ‘09 Rita Gunther McGrath [email_address] www.ritamcgrath.com www.discoverydrivengrowth.com

What do these companies have in common? Microsoft LexisNexis Federal Express Oracle Motorola Southwest Airlines CNN Hyatt Hotels Wikipedia Foundation General Electric Hewlett-Packard Google Procter & Gamble

Microsoft

LexisNexis

Federal Express

Oracle

Motorola

Southwest Airlines

CNN

Hyatt Hotels

Wikipedia Foundation

General Electric

Hewlett-Packard

Google

Procter & Gamble

Growth opportunities are abundant High end department stores extending their reach to new channels for personal items such as shoes AT&T and other telecom infrastructure providers dominating the market for VOIP applications Local newspapers and media companies creating on-line alternatives to classified ads & directories Sony taking advantage of its access to great content and fantastic engineering to serve up on-line music Time Warner capitalizing on Internet-based advertising and promotion But it ended up being… It could have been…

The basic assumption behind most tools for strategy Porter’s “Five Forces” explained profitability and competitive advantage Predictable and relatively stable patterns for profitability You could anticipate, based on analyzing the trends in the forces Advantages from scale, scope, transaction efficiency Copyright 2008 by Rita Gunther McGrath Industry Rivalry Firms producing Substitute products Suppliers Buyers Potential Entrants

Porter’s “Five Forces” explained profitability and competitive advantage

Predictable and relatively stable patterns for profitability

You could anticipate, based on analyzing the trends in the forces

Advantages from scale, scope, transaction efficiency

Why a different approach makes sense All advantages face erosion The window of profitability is shrinking Failure will become quite common Competence traps can prevent effective responses Finding new advantages takes time, and nobody has spare time these days Copyright 2008 by Rita Gunther McGrath

All advantages face erosion

The window of profitability is shrinking

Failure will become quite common

Competence traps can prevent effective responses

Finding new advantages takes time, and nobody has spare time these days

What we now understand Different disciplines are required for strategy under uncertainty than are appropriate for better-behaved situations Assumption to Knowledge ratio Cost, not rate Source: McGrath & MacMillan The Entrepreneurial Mindset 2000, Harvard Business School Press

Different disciplines are required for strategy under uncertainty than are appropriate for better-behaved situations

Assumption to Knowledge ratio

Cost, not rate

Think like a venture capitalist May, 2009 Venture 1 Venture 2 Venture 3 Venture 4 Venture 5 $ 100 investment Venture 6 Venture 7 Venture 8 Venture 9 Venture 10

May, 2009

Venture 1

Venture 2

Venture 3

Venture 4

Venture 5

$ 100 investment

Venture 6

Venture 7

Venture 8

Venture 9

Venture 10

And in three years? Not such good news… May, 2012 Venture 1 Venture 2 Venture 3 Venture 4 Venture 5 Venture 6

May, 2012

Venture 1

Venture 2

Venture 3

Venture 4

Venture 5

Venture 6

More not so good news… May, 2012 Venture 1 Venture 2 Venture 3 Venture 4 Venture 5 Venture 6 Venture 7 Venture 8 Venture 9

May, 2012

Venture 1

Venture 2

Venture 3

Venture 4

Venture 5

Venture 6

Venture 7

Venture 8

Venture 9

Hit the jackpot with venture 10! May, 2012 $5,000 return

May, 2012

Investing with confidence, even with a 90% rate of failure… Principles Substantial upside opportunity Relatively small downside risk Contained, known exposure at any given point in time A portfolio of opportunities Real Options Reasoning

Principles

Substantial upside opportunity

Relatively small downside risk

Contained, known exposure at any given point in time

A portfolio of opportunities

Real Options Reasoning

Every management decision has both NPV and Option Value Low High Uncertainty Present Value Option Value Source: Dixit & Pindyck. 1994. Investment Under Uncertainty Princeton University Press

Investing under uncertainty: An opportunity portfolio Technical and Execution Uncertainty High Medium Low External and Internal Market Uncertainty Low Medium High Positioning Options Stepping Stones Platform Launches Enhancement Launches Scouting Options

Let’s look at an actual portfolio of initiatives within a company The company: Manufacturer of medical devices (catheter tubes and a lot of other not-so-glamorous products) The problem: Slow commercialization, market laggard, despite heavy R&D spend The analysis: Identified each project in the commercialization pipeline and mapped it (not basic R&D, only those initiatives ready to move to the market) Size of bubble: upside potential of project – estimated payoff Numbers in bubble: Person-months to commercialize (rough equivalent of project cost/difficulty). Total months = 1180, or 98 person-years. Total staff at the time was about 25, meaning it would take about 3.9 years at this staffing level to deliver everything already within this portfolio Empty bubbles: proposed projects not yet allocated resources

The company: Manufacturer of medical devices (catheter tubes and a lot of other not-so-glamorous products)

The problem: Slow commercialization, market laggard, despite heavy R&D spend

The analysis: Identified each project in the commercialization pipeline and mapped it (not basic R&D, only those initiatives ready to move to the market)

Size of bubble: upside potential of project – estimated payoff

Numbers in bubble: Person-months to commercialize (rough equivalent of project cost/difficulty). Total months = 1180, or 98 person-years. Total staff at the time was about 25, meaning it would take about 3.9 years at this staffing level to deliver everything already within this portfolio

Empty bubbles: proposed projects not yet allocated resources

What do you think of this portfolio? High Medium Low Low Medium High Positioning Options Stepping Stones Platform Launches Enhancement Launches Scouting Options 125 200+ 25 25 110 95 75 210 35 5 120 75 75 5 Technical and Execution Uncertainty External and Internal Market Uncertainty

A Portfolio with Gaps Technical and Execution Uncertainty High Medium Low Market and Organizational Uncertainty Low Medium High Positioning Options Stepping Stones Platform Launches Enhancement Launches Scouting Options

A conservative portfolio Technical and Execution Uncertainty High Medium Low Market and Organizational Uncertainty Low Medium High Positioning Options Stepping Stones Platform Launches Enhancement Launches Scouting Options

It’s not hard to do a quick analysis Draw a portfolio on some big sheets of paper Make one sticky note for each critical project With your team, map them using the uncertainty score sheets as a point of departure What do you conclude?

Draw a portfolio on some big sheets of paper

Make one sticky note for each critical project

With your team, map them using the uncertainty score sheets as a point of departure

What do you conclude?

Characteristic Misalignment Strategy Budgets (planning) Projects People

Strategy

Budgets (planning)

Projects

People

A process change Determine where you want to place your emphasis What proportion of resources to which type of project? This is a strategic choice involving a number of considerations – pace of change in industry, strategy for extension or disruption of existing models, available resources, competitive positioning Allocate resources to each ‘bucket’ according to this decision Fund the very best proposals in each category, but resist the temptation to have projects in different categories compete (eg options vs. enhancements) Have a plan to move ‘options’ to ‘launch’ or eventually stop them Dynamically monitor – have projects’ status changed? Have your resources? Are you learning from previous experience?

Determine where you want to place your emphasis

What proportion of resources to which type of project?

This is a strategic choice involving a number of considerations – pace of change in industry, strategy for extension or disruption of existing models, available resources, competitive positioning

Allocate resources to each ‘bucket’ according to this decision

Fund the very best proposals in each category, but resist the temptation to have projects in different categories compete (eg options vs. enhancements)

Have a plan to move ‘options’ to ‘launch’ or eventually stop them

Dynamically monitor – have projects’ status changed? Have your resources? Are you learning from previous experience?

Executing the specific initiatives that are actually your strategy Discovery Driven Planning

A few from the flops file CargoLifter Millennium Dome Kodak/ Sterling Drug Webvan AOL/ TimeWarner Motors Revlon Vital Radiance PAX tire

Five disciplines, working together Define success before you start Impose market and competitive discipline Lay out clear operations specifications Articulate and document assumptions Plan to checkpoints Used for startups, corporate ventures, services businesses, governments & NGO’s, IT projects, B2B businesses…anything with a high assumption: knowledge ratio

Define success before you start

Impose market and competitive discipline

Lay out clear operations specifications

Articulate and document assumptions

Plan to checkpoints

Used for startups, corporate ventures, services businesses, governments & NGO’s, IT projects, B2B businesses…anything with a high assumption: knowledge ratio

Begin by defining the prize Profits - For an established business, say 10% increment in profits overall plus improvements in profitability Position - Clearly defined contribution to defensive position Or transformation potential - For a new business, what would make all the trouble worthwhile? Example Canon’s Yamaji

Profits - For an established business, say 10% increment in profits overall plus improvements in profitability

Position - Clearly defined contribution to defensive position

Or transformation potential - For a new business, what would make all the trouble worthwhile?

Example Canon’s Yamaji

Simple illustration: A Toy Story

Reverse income statement (for profits) Required Profits = necessary revenues minus allowable costs Required ROI = required profits / allowable investment Start with profits and permit costs, not start with costs and hope the profits will flow

Required Profits = necessary revenues minus allowable costs

Required ROI = required profits / allowable investment

Start with profits and permit costs, not start with costs and hope the profits will flow

Unit of business: Often harder than it looks Product-based businesses are usually the simplest to define When you start pushing into services, solutions or blended models (e.g., upgrades, insurance) complexity increases Consider the difference in cost to revenue ratios for Insurance Software Development Consulting Services The big danger? Bringing to one kind of business the assumptions drawn from another

Product-based businesses are usually the simplest to define

When you start pushing into services, solutions or blended models (e.g., upgrades, insurance) complexity increases

Consider the difference in cost to revenue ratios for

Insurance

Software Development

Consulting Services

The big danger? Bringing to one kind of business the assumptions drawn from another

Unit of Business: Internal & Not for Profit Situations Typically, you are looking for maximum returns for some kind of input. So, consider, Return on Time invested Return on Dollars invested Return relative to other opportunities That can help with tradeoffs – our favorite example of a pastor and flock-building

Typically, you are looking for maximum returns for some kind of input.

So, consider,

Return on Time invested

Return on Dollars invested

Return relative to other opportunities

That can help with tradeoffs – our favorite example of a pastor and flock-building

Unit of Business: Toy Store By the unit

Reverse income statement for Toy Store (this is REALLY simple!) $ 500,000.00 Required Revenues 50% Return on Sales $ 250,000.00 Required Before-Tax profits

Back to our toy store – what’s a back of envelope number? Total size of store? 3,100 square feet 1,250 Required purchases per peak week 8 Weeks during peak season 10,000 Required purchases 2 Average items per purchase 20,000 Number of items required $25.00 Average price per item

Second discipline: Discipline of the Market Critical market assumptions Spider farmers Apparel venture Critical technical assumptions

Critical market assumptions

Spider farmers

Apparel venture

Critical technical assumptions

Benchmarks: Toy Store? Average purchase in a Toys R Us store $10 or just under Average size of a Toys R Us store 20,000 square feet

Average purchase in a Toys R Us store

$10 or just under

Average size of a Toys R Us store

20,000 square feet

Hmmm…not looking so good But what about Build a Bear Workshop? 3,000 average store size $700 average revenue per square foot $2.1 M revenue potential per year per store That works!

But what about Build a Bear Workshop?

3,000 average store size

$700 average revenue per square foot

$2.1 M revenue potential per year per store

That works!

Or the American Girl Place? A day at American Girl Place can easily run about $300 for one adult and one child. It starts with the purchase of an $87 doll and paperback book. Visitors spend on average two hours at the store--watching the musical American Girls Revue at the in-store theater ($28 each), having lunch at the pink-and-black polka-dotted tea room ($20 each), visiting the doll hair salon ($10 to $20), posing for a picture at the photo studio ($23 to $35), perusing the doll museum (no charge), and shopping for doll outfits, doll furniture and doll accessories. http://www.prophet.com/newsevents/news/story/20070116story.html

A day at American Girl Place can easily run about $300 for one adult and one child. It starts with the purchase of an $87 doll and paperback book.

Visitors spend on average two hours at the store--watching the musical American Girls Revue at the in-store theater ($28 each), having lunch at the pink-and-black polka-dotted tea room ($20 each), visiting the doll hair salon ($10 to $20), posing for a picture at the photo studio ($23 to $35), perusing the doll museum (no charge), and shopping for doll outfits, doll furniture and doll accessories.

Third discipline: Specify operating challenge & document assumptions Questions along these lines: How many units do I have to sell to achieve my profit goals? Will this volume support a cost structure that achieves my profit goals? What kind of people infrastructure do I need to achieve my profit goals? How sensitive will my profits be to changes in the assumptions I am making?

Questions along these lines:

How many units do I have to sell to achieve my profit goals?

Will this volume support a cost structure that achieves my profit goals?

What kind of people infrastructure do I need to achieve my profit goals?

How sensitive will my profits be to changes in the assumptions I am making?

Operating Specs – Toy Store Calculation $ 43,720.00 Cost Buffer $ 206,280.00 Anticipated Costs $ 250,000.00 Allowable Costs Calculation $ 206,280.00 Total Anticipated Costs From above $ 33,280.00 Sales expenses per year From above $ 50,000.00 Inventory costs From above 93,000 Rent From above $ 30,000.00 Advertising/Marketing Expense Allowable cost analysis Source

An Assumption Checklist 5 Other biz experience Calculated Even Spread across year 4 Customer focus group Prototype session $25-50 Price range for product 3 August 2006 Mfg report Old Fashioned Merchandise mix 2 6/2006 Assumption No more than 75% ROS Operating Cost 1 Internet 6/2006 Local survey 20,000+ Market Size Assumption # Last Checked Source Data Element

Final discipline: Checkpoint planning Focus on converting assumptions to knowledge (plan to learn) Driven by checkpoint events At each checkpoint, revisit the assumptions and business model - what has been learned? Experiments and probes prior to full scale commitment, if you can

Focus on converting assumptions to knowledge (plan to learn)

Driven by checkpoint events

At each checkpoint, revisit the assumptions and business model - what has been learned?

Experiments and probes prior to full scale commitment, if you can

Map assumptions to checkpoints (no empty rows, no empty columns!)   5        4    3  2   1 7 6 5 4 3 2 1 Checkpoints Assumptions

Using CheckPoints to Sequence Risk: An industrial example

An Example from an IT project (internally oriented) $100,000 System cutover 12 $50,000 User testing 11 $50,000 Help desk training and certification 10 $200,000 User training & development of documentation 9 $300,000 Data clean up and conversion 8 $200,000 users & coders User iteration with interface and underlying functionality 7 $100,000 systems analysis Define code to go underneath the mock-ups 6 $100,000 users & coders User iteration with interface mock-ups 5 $50,000 systems analysis Specification development for initial prototype system – fraud reduction 4 $40,000 systems analysis Specification development for initial prototype system – efficient claims processing 3 $20,000 consulting project Estimated benefit of more efficient claims handling & better fraud detection / process analysis 2 $5,000 feasibility Assessment kickoff 1 Cost to achieve Checkpoint

What about the toy store? G. Willikers in Sacramento, CA. Copied from “YELP” You'd have to be the old Grinch above Whoville not to love this unique toy store that is chock full 'o fun stuff. Great place to find stocking stuffers and good quality novelty toys. A welcomed oasis in an otherwise shlocky and cheesy Old Sacramento, bless its heart. Dozens of wind-up toys, tin robots (Zzzzap!), wooden guns, interesting building sets, and large interactive displays throughout the store. Plenty of old school nostalgic toys, gags/tricks, and cool stuff. I do a lot of shopping for goody bags, both in town and online. There are other stores that sell small amusing trinkets for a cheaper price. (See my party list for recommendations.) I think this store has an excellent selection -- but keep in mind better quality comes with a price. Party hats off to G. Willikers. “ We HAVE to stop by this place every time my son and I take the train to Sacramento. And honestly...I don't mind. It's a lot of fun. Stuff for the kid in all of us. They have stuff for both girls and boys. One big section dedicated entirely to Thomas the Tanks Engine. One big HUGE mountain train set right in the middle of the store. Actually, It's a working volcano if I remember right. Also several different train set-ups throughout the store. Cool old retro toy section, as well as new stuff. Don't miss this store if you are in the old town Sac area.”

Copied from “YELP”

You'd have to be the old Grinch above Whoville not to love this unique toy store that is chock full 'o fun stuff. Great place to find stocking stuffers and good quality novelty toys. A welcomed oasis in an otherwise shlocky and cheesy Old Sacramento, bless its heart. Dozens of wind-up toys, tin robots (Zzzzap!), wooden guns, interesting building sets, and large interactive displays throughout the store. Plenty of old school nostalgic toys, gags/tricks, and cool stuff. I do a lot of shopping for goody bags, both in town and online. There are other stores that sell small amusing trinkets for a cheaper price. (See my party list for recommendations.) I think this store has an excellent selection -- but keep in mind better quality comes with a price. Party hats off to G. Willikers.

“ We HAVE to stop by this place every time my son and I take the train to Sacramento. And honestly...I don't mind. It's a lot of fun. Stuff for the kid in all of us. They have stuff for both girls and boys. One big section dedicated entirely to Thomas the Tanks Engine. One big HUGE mountain train set right in the middle of the store. Actually, It's a working volcano if I remember right. Also several different train set-ups throughout the store. Cool old retro toy section, as well as new stuff. Don't miss this store if you are in the old town Sac area.”

Discovery Driven Strategy requires a different leadership mindset (try the diagnostic) Termination handled with grace Termination delayed Downside anticipated Downside avoided Assumptions explicitly checked Assumptions taken for granted Released funding All at once funding Change of direction essential Change of direction bad Cost of failure Rate of failure Maximizing learning Making the numbers To… From…

Conclusion These are tough times Nonetheless, there are lots of opportunities to be seized Use the right disciplines to reduce risk at the same time

These are tough times

Nonetheless, there are lots of opportunities to be seized

Use the right disciplines to reduce risk at the same time