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Bus strseries unlockingvalue-sept2010 -psds

  1. 1. Published in Business Strategy Series September 2010 A New Model for Unlocking the Value of Entrepreneurial Businesses By Peter Skarzynski and Doug Schaedler Peter Skarzynski is a Senior Managing Director and founder of Strategos, a global strategy In December 2009, a student team from MIT won the Red Balloon Challenge organized by the Defense Advanced Research Projects Agency (DARPA), an agency of the U.S. Department of Defense responsible for developing new technology for military use.1 The team took just nine hours to track down the locations of ten red weather balloons hidden across the United States, exceeding even the event organizer’s wildest expectations. The team’s innovative reverse-Ponzi reward system that encouraged knowledge owners to participate in its social network will be studied and replicated by many. However, the even more impressive feat was that the team took just one week to design, plan and operationalize the whole system.2 This team’s success is a landmark example of the power of open innovation – both in terms of the productivity of a well-organized network and the swiftness with which such a network becomes operational. The success of the MIT Red Balloon Challenge Team highlighted open innovation as a maturing and 1 2 3 potentially powerful management practice, especially applicable for entrepreneurial businesses without rigid organizational lines and ingrained business processes. Innovation pioneers are also successfully employing two other management practices, namely experimentation-driven discovery and future-back migration mapping, with both techniques being widely discussed and written about by management experts in recent years.3 Used together in one integrated management system, all three practices – open innovation, experimentation-driven discovery, and future-back migration mapping – could help dramatically reduce the risks of nascent businesses, essentially unlocking their value. The resultant unlocked value creates a bigger pie that allows everyone a bigger slice – a win-win for businesses and their capital providers. Understanding Entrepreneurial Business Risks Before we get into the risk reduction prowess of management practices and innovation consulting firm and the strategic services division of Innovaro. For over 20 years, he has helped senior managers set strategic direction, capture new growth opportunities and make their organizations more innovative. Doug Schaedler is the former CEO of Innovaro, a global intellectual property licensing and innovation service provider. He possesses deep operational experience in funding and nurturing startup businesses through his work as a founder, operator and investor at a wide range of startup companies. Learn more about the authors, Strategos, and Innovaro at www.strategos.com and www.Innovaro.com. From Defense Advanced Research Projects Agency (DARPA) website: https://networkchallenge.darpa.mil/default.aspx: “To mark the 40th anniversary of the Internet, DARPA has announced the DARPA Network Challenge, a competition that will explore the roles the Internet and social networking play in the timely communication, wide-area team-building, and urgent mobilization required to solve broad-scope, time-critical problems. The challenge is to be the first to submit the locations of 10 moored, 8-foot, red, weather balloons at 10 fixed locations in the continental United States. The balloons will be in readily accessible locations and visible from nearby roads.” While the MIT Red Balloon Challenge Team used the open innovation approach, Google’s internal team applied number crunching and image recognition techniques (e.g., looking for images and posting of red balloon locations on the web). When MIT Red Balloon Challenge Team successfully identified all ten balloons, the Google team had found nine. https://networkchallenge.darpa.mil/Default.aspx; http://socialcapital.wordpress.com/2009/12/11/behind-mits-darpa-weather-balloon-challenge-win/ ; http://www.networkworld.com/news/2009/120509-layer8-darpa-mit-red-balloon.html?fsrc=netflash-rss; http://news.cnet.com/8301-1023_310411211-93.html See Discovery-Driven Growth: A Breakthrough Process to Reduce Risk and Seize Opportunity, by Rita McGrath and Ian MacMillan (Harvard Business School Press, 2009); Unleashing Innovation: How Whirlpool Transformed an Industry by Nancy Tennant Snyder and Deborah Duarte (Jossey-Bass, 2008); and Innovation to the Core: A Blueprint for Transforming the Way Your Company Innovates by Peter Skarzynski and Rowan Gibson (Harvard Business School Press, 2008). © Copyright 2010 Strategos. All rights reserved.
  2. 2. like open innovation, experimentationdriven discovery, and future-back migration mapping, let’s first look at the risks themselves. While every business operates in a unique situation and has a set of risks specific to it, there are four types of risks common to virtually all entrepreneurial businesses, whether they are venture-backed startups or new businesses within established companies: customer demand, product or technology development, profitability of the business model, and competitor response or product obsolescence. • Customer demand risk – Does the business offer a product and/or service that addresses a customer problem or need? Will customers be willing to pay (with money or time) for the product or service? Are there enough paying customers? Because many innovative businesses’ new products or services address unmet needs that most customers don’t even know they have, it’s often extremely difficult to determine customer demand levels for them. For example, before the introduction of the Apple iPod, consumers couldn’t take their entire collection of entertainment content with them. So, market data to gauge the potential size of the market for the iPod didn’t exist. For other businesses, their new products or services offer better solutions over current offerings or work-arounds. Here, new customers would incur switching costs in addition to new product/services costs. Many “better mouse traps” never leave their inventors’ garages because they couldn’t overcome switching costs. • Product / technology development risk – Many great inventions start with a big promise but never develop into successful commercial endeavors. So, business innovators must assess and manage the risk of evolving the invention from concept to commercial product. In parallel, they need to figure out how to scale up the business and if the end-product or technology can withstand the wear and tear of daily use. Twenty years ago, multiple corporate network software companies were working on word processors that would allow dispersed team members to collaboratively edit the same document in real time. Despite the potential benefit, this capability still eludes corporate productivity software even now. • Profitability (business model) risk – Ultimately, all businesses need to generate sufficient profits to be sustainable. So, innovators must determine the specific economic business model for their businesses. In addition to the simplistic perspective that the cost of delivering the product or service must be lower than the revenue received from same, there are many business model issues. These range from customer awareness and delivery to complementary revenue sources and specific pricing schemes. Many startup businesses like Netflix are centered on innovation in the business model, not just the fruits of technological inventions. Innovators must understand and manage the risks associated with the novel aspects of their particular business model. • Competitor/market/product obsolescence risk – Assuming the entrepreneur can successfully launch the product or service, competitors will respond. Because the distinct advantage of any product or service will ultimately be overtaken by newer products and services, every product and service faces the threat of obsolescence. Mitigating Entrepreneurial Business Risks and Unlocking Value The MIT Red Balloon Challenge Team is just one recent example of the victory of open innovation. Add to this the success of Linux and Wikipedia (and all the derivative © Copyright 2010 Strategos. All rights reserved. Wikis), and it’s clear that the practice has demonstrated its power to dramatically improve the productivity of massive development projects and its effectiveness in solving complex problems. It should come as no surprise that open innovation can help reduce the risks of startup businesses and intra-preneurial ventures. Experimentation-driven discovery and future-back migration mapping have also helped both established and nascent companies mitigate the risks of innovative businesses. Let’s look at how innovators can use these three management practices to reduce entrepreneurial business risks and unlock value. Crowd-Sourcing/Open Innovation allows a group of people, often volunteers or self-nominated, to jointly work on a complex problem or project, with little or no prespecified group hierarchy. How does this work in practice? Estimating customer demand and market size remains an imprecise art. Practitioners generally collect a wide range of data, including potential customers’ impressions of the new product/service, and then benchmark that pre-launch data against previously collected pre-launch data for past new products/services. They use the comparisons to estimate the potential successes of new products/services. However, “prediction” markets have proven to be extremely accurate without the need to collect extensive data or construct a benchmarking model. A prime example is the University of Iowa Electronic Market (IEM), which has been accurately forecasting the outcome of U.S. elections since 1988 via on-line futures markets. According to Tom Rietz, associate professor of finance at the University of Iowa, the prediction error for presidential elections between 1988 and 2000 was 1.37%, and in other elections (such as Senate, House, and primaries) averaged 3.43%. Compared to major polling organizations, IEM was more
  3. 3. accurate 76% of the time in predicting the outcome of elections. Hewlett Packard has applied this technique to supplement its printer sales forecast, and Google has used it to estimate product launch dates. Even DARPA has explored applying the technique to estimate the likelihood of a terrorist attack.4 Inventing novel techniques for solving complex problems is potentially the best strength of crowd-sourcing. One example is the Netflix Prize, an open competition for the best collaborative filtering algorithm to predict user ratings for films, based on the users’ previous ratings. (This allows Netflix to recommend movies that a given user would be more likely to rate “high.”) The grand prize of $1 million was reserved for the entry which would best Netflix’s own algorithm by 10 percent. Although it took three years before a multinational team overcame the 10% threshold, Netflix’s own internal engineers probably would have taken even longer and done so at a substantially higher cost.5 Experimentation-Driven Discovery is a practice where elements of a new business concept are tested and then refined, in real or simulated market conditions. Many companies have applied a wide range of experiments and tests to gauge customer demand. One example is Google’s Gmail, a highly popular web mail application. Google first evaluated customer demand by testing it with users inside its own firm. Once it was clear that employees found Gmail useful, Google slowly invited the public to try it out, limiting invitees to a select few. As word spread about the advantages of Gmail over other web mail applications, demand swelled, and invitees auctioned off their Gmail invitations on eBay for 4 5 6 7 hundreds of dollars. Google gradually tested its ability to deliver the product to a mass audience by slowly raising the number of invitations and steadily increasing the amount of storage space provided to each user. Gmail’s interface and security evolved as developers worked their way through the learning and development process. Another example of experimentationdriven discovery is Best Buy’s Trade-In program, which encourages customers to bring in certain used electronics in exchange for Best Buy gift cards or free/low-cost environmentally safe disposal. Shortly after conceiving the idea, Best Buy tested the concept in a few stores with temporary tents in store parking lots. To market the service, employees left flyers with neighborhood households. These low-cost experiments provided valuable data that confirmed the customer demand for and overall business model soundness of this new line of business. Now, Best Buy is rolling out the program across its entire network of stores. Interestingly, one of the surprising lessons learned was that disposal of the used electronics can also be a profit center. Since then, Best Buy acquired Deal Tree and its subsidiary Cow Boom, and it’s investing in Cow Boom to sell the used goods collected from the Trade-In program.6 Experimentation is not just about proving the business founder’s original hypothesis; it’s also a powerful practice for revising the core business concept until a winning one emerges. An example of this is McDonalds’ experience in developing the RedBox business. At first, McDonald’s envisioned setting up self-service vending machines in its restaurant parking lots, offering a choice of goods similar to those sold in convenience stores. Its initial test uncovered multiple operational issues, such as securing permits for connecting power to a free-standing device in a parking lot. More importantly, it learned that among the 150 or so products offered, ranging from batteries to milk, DVDs really drove sales. So, McDonald’s morphed the concept from a generalpurpose convenience store to a DVD rental kiosk. They then conducted additional experiments to test pricing, assortment, and various operational issues. They also realized that they could expand the concept beyond the physical locations of their restaurants. Now, there are over 15,000 RedBox DVD rental kiosks across the country, many of them in supermarkets and other nonMcDonald’s properties, making RedBox the largest operator of DVD rental kiosks in the U.S.7 Jumping head first into the pool without testing the water can be dangerous. One example of launching a full-scale business without appropriate confirmation of the business model assumptions also happens to be one of the Internet bubble’s spectacular failures, Webvan, which consumed over a billion dollars of start-up capital in just a few years as it flailed in the business of home grocery delivery. While expectations were high, the concept had two business model risks, how much customers were willing to pay for the service and the right model for actually delivering groceries to consumers. Instead of first conducting low-cost experiments, Webvan immediately constructed proprietary warehouses in multiple cities. At the same time, Peapod (US) and Tesco (UK) were conducting low- cost experiments through their own existing supermarkets, diligently testing and refining the business model of home delivery of groceries. By the time Webvan learned that it would take an average consumer purchase of $200 “Business intelligence worth betting on,” ZDNet, 7/13/2003, http://news.zdnet.com/2100-10532_22-296373.html “And the Winner of the $1 Million Netflix Prize (Probably) Is …”, New York Times, 7/26/2009; “Netflix Prize,” Wikipedia “Best Buy’s Trade-In Plans: ‘Why Let eBay Have All The Fun?’ ”, StorefrontBacktalk, March 4, 2010, http://storefrontbacktalk.com/e-commerce/best-buy-preparing-to-buy-back-used-products-envisions-profitable-untouched-lifecycle-potential McDonald’s sold the majority of its stake in RedBox to partner Coinstar in February 2009. © Copyright 2010 Strategos. All rights reserved.
  4. 4. for its proprietary warehouse model to break even, it had already burned through its IPO cash, and went bankrupt shortly after that. Meanwhile, Peapod and Tesco continued to experiment and then apply the lessons learned to refine their delivery model into a workable solution. Now, they are not just surviving, they are viable and growing in the business of delivering groceries to people’s homes. Future-Back Migration Mapping, a practice that organizes a group of similar ideas, delivers a gamechanging benefit to the customer, in logical sequential paths. Instead of relying on a single breakthrough product, innovators think of a collection of products that together greatly transform the customer value the company delivers. Then, they construct a migration map from the end-state transformative ambition back to a set of lower-risk early-stage products. Essentially, a company starts with its vision of the future, and then maps a path back to it from where they are now. A good example of the use of futureback migration mapping is the development of the Apple iPod. Imagine that you were a top executive at Apple at the turn of the millennium, and that you were presented with the opportunity to develop a Macintosh-only digital music player. Would you have devoted your company’s top engineers and designers to this project? If you say “no,” you are not alone. On the surface, a Mac-only anything seemed to be a small opportunity, and MP3 players were simply not a core business for computer makers. Most seasoned managers would also have said “no.” Fortunately for Apple, that’s not the whole story. The initial iPod product and iTunes service were just the first steps in Apple’s ambitious “Digital Hub” strategy, where the ultimate goal was to allow users to have all the entertainment content they want accessible to them whenever and 8 Figure 1 – Hypothetical Illustration of the iPod Migration Map wherever they want it. See Figure 1 above for a hypothetical illustration of the Digital Hub strategy and a retrospective illustration of Apple’s Digital Hub platform migration map. From this strategic perspective, the Macintosh-only digital music player was a low-risk entry point, where Apple could refine its business model while getting major music labels and other partners to collaborate. The migration map approach helped Apple identify a starting point that mitigated many of the business model risks. Additionally, the migration map approach helped Apple evolve its products and reduced development risks. Specifically, while great design and ease of use have always been a core value and a key competence of Apple, the early lessons learned from the first few generations of iPod and iTunes helped Apple refine its points of differentiation. Apple also learned early on how to generate consumer buzz. When it launched the first three generations of iPods, Apple centered its marketing efforts on touting the expanded array of functions and features (what it could do). Out in the marketplace, the buzz came from the slick “click”8 wheel (how it’s done), as early owners busily showed off their cool devices to their friends. Apple learned that the collision of “Click” wheel was a feature for the third generation iPod. © Copyright 2010 Strategos. All rights reserved. sophisticated technologies with coolness generated consumer buzz. So it painstakingly built nifty ways to perform ordinary tasks in later editions of everything, from scrolling miniature pictures of album covers for browsing the music library to “jiggling” icons when customizing the home-screen on an iPhone. Amazon has also used future-back migration mapping. In the early days, Amazon.com was a true Internet company. Not only was it without a physical storefront, it didn’t even handle the books it sold, instead relying on book distributors as partners for processing the actual orders. Then, as eCommerce took off, Amazon saw eCommerce infrastructure as a potential long-term growth space. Amazon formulated a strategy that positioned it as the eCommerce platform provider, handling its own transactions as well as providing online storefronts and order processing capabilities for other retailers, large and small. With this end-state vision in mind, Amazon raised capital and constructed proprietary warehouses and distribution centers, along with sophisticated warehouse and distribution management software, to handle the delivery of products for itself and its partners. In parallel, it also invested heavily in eCommerce
  5. 5. technologies for presenting its own and its partners’ products to consumers. This long-term migration enabled Amazon to remain viable despite constant competitive threats. Conclusion Google, Netflix, and Amazon.com were successful ventures that started in the dot-com era, and their successes rewarded investors and their entrepreneurial founders handsomely. Despite the successes of these three stars and other wellknown venture capital-backed startups like eBay, Apple, and Intel, many good business ideas, in both venture capital and corporate environments, don’t get funded. At the same time, many poorly conceived ventures should be terminated long before they burn through so much investor money or corporate capital. A systematic approach to assessing and mitigating risks associated with innovative business is highly valuable for business managers and their funding providers. If we extract lessons from the experiences of successful startups and innovative ventures from established firms, it seems the practices of open innovation, experimentation-driven discovery, and future-back migration mapping can form the foundation of a systematic toolset for assessing and mitigating the basic risks, and www.strategos.com © Copyright 2010 Strategos. All rights reserved. therefore unlocking the value, of entrepreneurial businesses. Although these practices will not assure that all new business ideas will grow and prosper, they will help management and funding providers in both VC and corporate environments weed out unviable ideas while nurturing promising opportunities that evolve into successful businesses. The end result should be that more good ideas will be funded, creating greater returns for capital providers and opportunity managers.