How Big Companies Can Innovate

Co-authored with Nicholas Drake


Photo Credit: Vittal Iyer

"So I said okay, this is outrageous this is a small, startup car company on the West Coast [Tesla Motors], obviously very confident about lithium ion batteries and is going to go into production with this car and we [General Motors] many people would say technologically the most competent car company in the world, we say it can't be done. So then we got into the well maybe let's take a look phase which was the beginning of the Volt development... whether Tesla is ever hugely successful or not I'll always owe him a debt of gratitude for having kinda broken the ice."

- Bob Lutz, (former) CEO of General Motors

Despite the rhetoric to the contrary, most big companies have a reputation for not being very innovative. Whether it is because of diseconomies of scale, monopoly power or simple complacency it is widely accepted that it is start-ups that are the real source of innovation and technological progress in our economies.

What we want to argue in this essay is that start-ups both cannot and should not be the only source of innovation in our societies. Start-ups are by definition risky and rarely do they have the balance sheet of more established companies that is necessary to invest in highly capital intensive industries, in which the future major breakthroughs in technology will occur in.

This has led, understandably, to a severe bias in VC investing towards software and internet based companies. As Peter Thiel's Founders Fund, his venture capital firm, has glibly noted: 'We wanted flying cars, instead we got 140 characters.' We need to ask ourselves how big companies can innovate more.

Typically the answer has focused around company culture and what Tim Brown, CEO of IDEO, has called developing a 'pipeline of creative talent.' Although these are no doubt important they are not the full picture. We shall try to argue here for four proposals that we think shall meaningfully change the incentive systems and corporate structures to incentivize more innovation.

First, we propose that big companies should change their organizational structure from a hierarchical one to one where employees can pitch to a VC like 'board of directors.' There are three advantages of this structure. Firstly it offers smart young employees an alternative track for career development from the twenty or thirty years of working up the corporate ladder. The traditional career track makes employees risk averse and more focused on playing the 'office politics game.'

This leads to the second advantage, which is diversifying of ideas that are brought to the table. The third advantage is that in hierarchical company structures when big projects come along the politically savvy will try and get as many senior managers involved as possible the reasoning being if it goes wrong blame can't be allocated without it being self-incriminating.

This is exactly what you don't want when taking risks. As author Michael Lewis has written, [entrepreneur Jim] "Clark liked to say that human beings, when they took risks, fell into one of two types, pigs or chickens. The difference between the two is the difference between the pig and the chicken in the ham-and-eggs breakfast. The chicken is interested, the pig is committed. If you are going to do anything worth doing, you need a lot of pigs.''

Our second proposal is to hire not just on an individual basis but also duos and small teams. The reason for this is that companies usually involve three types of role 1. the actual work 2. management and 3. strategic decision making. In a typical company the junior people do the first and the senior people the second and third.

What this means is that there is a strong bias against people who do not have managements skills in senior management even if they can contribute to the strategic decision making in a meaningful way. Our proposal is to copy start-ups where founders can get away with being 'not well-rounded' individually as long as they are collectively.

As an example, a big corporation might hire a duo where one is more socially attuned, with strong communication skills and an understanding of office politics whilst the other might have strong domain expertise or contrarian approaches to thinking. Hiring teams rather than individuals would be a way to diversify the types of people that succeed in working their way into senior management.

Our third proposal is to figure out ways to give CEOs more dictatorial powers. The typical narrative is that companies fail to innovate because they fail to unlock the creative talents of their employees. Indeed everyone can innovate but they are just not given the opportunity to.

We argue that exactly the opposite is true because big companies suffer from an over democratization of power not a lack of it. Most innovative companies today as Google and SpaceX tend to be structured like start-ups where the founders have retained immense internal power to green light projects, regardless of whether their boards agree to them or not. This of course, for any company, can be very dangerous because if you give the wrong man too much power he may abuse or misuse it.

However, from a societal stand-point you want big companies to be able to take big risks. Part of the solution is cultural, part of it is how the corporate hierarchy is structured. We argue a huge part is a company's relationship with the capital markets, in particular how to make sure companies aren't beholden to quarterly statements and the 24 hour news cycle.

Michael Dell felt the incentives for being a public company were so short-term driven that he actually took Dell private again. He argued that, " a private entity, we can take on risk. We can accept risks and invest more aggressively.' Unfortunately, from a societal stand-point having all companies go private is unrealistic since capital markets offer a valuable source of funding.

Is it possible to keep the benefits of access to capital markets without its disadvantages? It is difficult to speculate what the answer is, but we must we find a solution, which harnesses long-term thinking while maintaining liquidity.

Our fourth and final proposal is to spread the risks of investment more aggressively over multiple stake-holders. For example, it is very common in America for big infrastructure projects to be financed through public-private partnerships. The government will pay for the initial start-up costs but through releasing a rated bond the market can also take some of the risk. We believe something similar could be done with companies.

As an example, Steve Jobs and Apple carried a big risk when they developed the iPad. Understandably many companies refrain from such investments. Perhaps to adopt from the iPad example Apple could issue a bond or a form of equity that allows investors to invest in the future returns of a specific product. Allowing a bet on a specific product allows investors to leverage their investments better and allow companies to take bigger risks because it's not only on their balance sheet.

In conclusion, we believe that the single most important problem that management as a discipline needs to solve is how to make big companies more innovative. We believe the solution is not simply about changing culture or employing more creative people, both very easy to talk about but difficult to measure or disprove. Instead big companies need to actively change the incentive systems and corporate structure which big companies work under.

As Berkshire Hathaway's Charlie Munger observed on the topic, "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes [without me] getting some surprise that pushes my limit a little farther."