Creative Construction

INTRODUCTION

Innovation’s Catch-22

One of the many unforgettable scenes in Joseph Heller’s Catch-22 culminates in Yossarian’s insight that “Orr would be crazy to fly more missions and sane if he didn’t, but if he was sane he had to fly them. If he flew them he was crazy and didn’t have to; but if he didn’t want to he was sane and had to. Yossarian was moved very deeply by the absolute simplicity of this clause of Catch-22 and let out a respectful whistle. ‘That’s some catch, that Catch-22.’”

Yossarian would perhaps also be deeply moved by the paradox of innovation, one that comes with its own special catch. Innovation spawns growth, and growth by definition leads to scale, but scale seems to make the task of innovation more difficult. Even worse, the imperative to innovate keeps escalating because competition is dynamic. Rivals and new entrants eventually imitate what you have or come up with something even better. The more you succeed at innovation, the more you need to keep innovating, but the harder the task becomes. It is like those cardiac stress tests where the medical technician turns up the speed of the treadmill every time you get comfortable. You might be forgiven for thinking the technician is trying to kill you. Fortunately, the technician (usually) knows enough to stop the test before you have a heart attack. But competition does not work this way. No one is turning down the dial. In fact, competitors really do want to kill you!

Companies innovate to grow. It is hard to think of many companies in the past hundred years that achieved significant scale without being an innovator. Industrial giants of the twentieth century—DuPont, RCA, Ford, General Electric, Disney, Johnson & Johnson, McDonald’s, IBM, Walmart, Kodak, Intel, Microsoft—and those of the twenty-first century—Apple, Google, Amazon, Facebook—were all innovators of either technology or business models. Innovate and you grow. This is the promise. It’s why in 2017 US companies invested about $365 billion on R&D. Globally, corporate R&D expenditures topped $700 billion in 2017, according to the most recent estimates.¹ It’s why venture capitalists invested $155 billion in 2017.² And why every company CEO talks about the imperative to innovate and why business school executive programs on innovation are oversubscribed. Like all promises, though, this one comes with a catch.

The idea that successful innovators sow the seeds of their own destruction was originally posed more than seventy years ago. The great Austrian economist Joseph Schumpeter described a process he termed “creative destruction” whereby existing “economic structures” (which included existing enterprises) could be destroyed by either technological innovation or organizational innovation.³ Writing in 1939, Schumpeter was particularly astute in recognizing that established successful enterprises were vulnerable to the “gales of creative destruction”:

Beginning in the 1980s, a set of scholarly studies began to unearth the underlying reasons why once-successful innovators might ultimately be swept away by the winds of creative destruction.⁵ As the autopsies piled up—Xerox, RCA, Polaroid, Kodak, Wang, DEC, Nokia, RIM, Sun Microsystems, AT&T, Yahoo, and many others—a depressing picture emerged. Large established enterprises not only appeared to be incapable of leading any type of revolution; they could not even respond to attacks by new entrants. Their organizational pathologies included inertia and growing bureaucratization, loss of tolerance for risk, fears about cannibalizing existing products, ingrained processes for R&D, commitment to existing technologies and assets, religious adherence to current business models, an overreliance on flawed financial metrics, and leadership myopia. When it comes to innovation, large enterprises looked like patients suffering from multiple deadly maladies.

The thesis that large corporations cannot succeed at transformative innovation has been repeated so often by so many that—like some law of nature—it is no longer questioned. This is not just an academic issue but also one that influences management practice. Even leaders of many larger enterprises seem to have surrendered to the “fact” that they cannot grow organically through innovation but instead must buy innovation through acquisitions. Investors and analysts also believe it. They pressure larger enterprises to cut back on riskier, long-term research projects to free up cash for stock buybacks and dividends. The highly influential investment bank Morgan Stanley, for instance, issued an analyst report in January 2010 recommending that pharmaceutical companies dramatically slash internal research spending and instead focus on in-licensing development drugs from external sources.⁶ Citing the industry’s poor track record of R&D productivity, the report argued that buying innovation from the outside offered a better return on investment. The implicit assumption in this report is that larger companies are inherently less capable of innovation than are smaller biotechnology companies.

Transformative innovation inside a large enterprise is viewed as a complete waste of shareholder money. Better to return the money to shareholders, who can give it to venture capitalists to invest in start-ups. When I told a longtime venture capitalist friend of mine that I was writing a book on innovation in large enterprises, he smiled wryly and said, “At least it will be a short book. They can’t.”

Large organizations are said to lack the DNA for innovation. This genetic metaphor is powerful because for natural species (like us humans), capabilities are deeply rooted in DNA. DNA explains why a cheetah runs faster than an elephant. And, in natural species, DNA is essentially immutable for the individual. Growing up in Westwood, Massachusetts, I dreamed of playing for the Boston Celtics. Unfortunately, my DNA (or, more precisely, the DNA I inherited from my parents) endowed me with neither great height nor much athletic prowess. And, no matter how many hours I practiced in the driveway, there was nothing I could do to change my DNA. This is where the metaphor breaks down. Natural laws, like those associated with genetics, govern natural phenomena. Organizations, of course, are not natural phenomena; they are completely man-made, designed and run by people. “Organizational DNA” is not immutable. Unlike you or me, organizations can manipulate their own DNA. Through systematically creating an innovation strategy, designing an innovation system, and building an innovation culture, organizations develop the capability for transformative innovation regardless of scale. If larger enterprises seem incapable of transformative innovation, it is because we design them and run them to be that way. Creative Construction examines how we can design and run them differently in order to better succeed at innovation.

Small Is Beautiful Does Not Mean Big Is Ugly

There is no doubt that entrepreneurial firms are a potent source of transformative innovation. Entrepreneurial firms have revolutionized countless industries, from software and semiconductors to beer and biotechnology. Whenever you see an industry transformed, you usually do not have to look far to see an Intel, an Apple, a Microsoft, a Genentech, a Netscape, an Amazon, a Google, a Netflix, or an Uber. Yes, many (many!) start-ups die. We only get to celebrate the few big winners, but as an organizational species, entrepreneurial firms are spectacularly successful innovators. When it comes to innovation, small can be beautiful.

Does this mean, though, that big must therefore be ugly when it comes to innovation? I spend a lot of time in both entrepreneurial firms and very big companies as researcher and advisor. And, at first glance, the answer would seem to be yes. Instead of the creative focus, energy, and youthful enthusiasm of the start-up, I too often find endless hours of meetings, labyrinths of procedures and policies, and decision making mangled by byzantine organizational matrices. Whereas the start-up wants to be a Formula 1 race car (fast, agile, not very reliable, and sometimes pretty dangerous), the large enterprise emulates a freight train—predictable, boring, and rigid.

You may have made the same observation or even experienced the difference directly by moving from a big corporation to a start-up or working in a start-up acquired by a big corporation. You might have worked in a successful start-up that, thanks to its success, became relatively large. I have come across many instances where the transition from Formula 1 race car to freight train happened relatively fast in the life of a company. One day, it was a nimble, hungry start-up aspiring to revolutionize an industry; a few years later, after it had $1 billion in annual revenue, it was a freight train barreling down a single track. But this observation raises a few questions. Is this state of organizational affairs inevitable? Are the innovation-stifling characteristics we commonly see in a larger organization inherent to its large scale, or are they simply the artifacts of conscious or unconscious design choices made by its leaders? Are successful young companies really doomed to become lumbering freight trains if they are fortunate enough to grow? Must big be ugly when it comes to innovation?

Despite our perception about smallness and beauty and bigness and ugliness, it may be surprising that statistical evidence relating company size and innovation paints a far more nuanced picture.⁷ Big does not always mean ugly. Scale alone is not an impediment to innovative capacity. My own work on this topic compared the R&D productivity of large pharmaceutical companies to that of biotechnology companies from 1984 to 2004.⁸ At the time I performed the study, the conventional wisdom in the industry was that large pharmaceutical companies were less productive at R&D than smaller biotechnology companies (the same logic underpinning the Morgan Stanley analyst report). But my study—which traced the origin of every drug approved over a twenty-year period by the largest twenty pharmaceutical companies and more than 250 biotechnology companies—showed a “statistical dead heat” between the R&D productivity of both types of companies. So much for the hypothesis that big is ugly.

But what about transformational innovation—the type that ushers in waves of creative destruction and leads to upheavals of entire industries? The evidence here is a bit clearer but still not completely without important wrinkles. In general, innovations that disrupt specific industries tend to originate from new entrants.⁹ I stress “tend” because there are important exceptions. Consider, for instance, that Intel revolutionized the semiconductor industry by inventing and commercializing the microprocessor. Intel, however, was already a semiconductor company; it was not a new entrant into the semiconductor industry when it invented and commercialized the microprocessor. Second, I stress “entrants” because there is a big difference between a new firm (a start-up) and a new entrant. Established firms can be new entrants if they diversify from one industry to another. Waves of creative destruction can originate from firms of any size. Large size does not prevent companies from being transformative innovators.

Let’s consider some historical and more recent examples. In April 1964, IBM introduced the 360 line of mainframe computers.¹⁰ Prior to that time, every new machine required the development of a unique new operating system and hardware. There was little if any interchangeability between machines, even those made by the same company. This was becoming incredibly costly because everything had to be developed from scratch. It also made maintenance and support a major headache. IBM revolutionized computer architecture by creating common underlying software, like the operating system, and hardware that could be used across multiple machines. Today, we take this concept of modularity and interoperability for granted. In 1964, it was unheard of, and it completely revolutionized the computer industry. It triggered an explosion in demand for mainframes, and it created new markets for peripherals and software development. In 1964, IBM was neither a start-up nor a new entrant into the computer industry. It was already the largest computer company in the world and ranked number 18 on the Fortune 500 that year (its sales of $2 billion would be equivalent to approximately $15.5 billion today after adjusting for inflation).¹¹ This is a great example of a large, dominant incumbent in an industry disrupting the very industry in which it competed. Most theories of innovation say this is not supposed to happen. But it did.

Let’s take another example. In 1982, a team of scientists modified the genetics of a plant cell, an invention that laid the foundation for today’s genetically modified crops. Despite the controversy, it is hard to dispute the economic significance of this innovation. GMOs account for the vast majority of soybeans, corn, and cotton produced in the United States and transformed the agricultural seed industry. But this invention did not come from a start-up. It came from a team of scientists working at then-eighty-one-year-old Monsanto Corporation, a behemoth agricultural chemicals company (ranked number 50 on the Fortune 500 in 1982, with sales of $6.9 billion, the equivalent of $17.1 billion today). At the time, Monsanto was not even in the seed business, but today it is the world’s largest seed company. This is an example of a large player from one industry transforming itself and another industry through innovation.

There are many other historical examples of large companies succeeding at transformative innovation. Think about 150-year-old Corning, which invented fiber-optic cable and the glass manufacturing processes critical to today’s computer, television, and phone displays. And, of course, Bell Labs almost single-handedly drove the transformation of the twentieth century with a series of inventions such as the transistor, the microwave, cellular communications, the laser, satellite communications, digital transmission and switching, solar cells, and the Unix operating system (among many others). Bell’s massive size did not seem to impede its capacity for innovation.

Well, then, you may think, “History is fine, but times have changed. The day of the big lab is dead. We live in the age of entrepreneurs.” So, let’s move closer to the present: Apple. Everyone knows the story of how the iPhone completely redefined the market from mobile phones to mobile communications. It was both a classic Schumpeterian gale—destroying once-mighty incumbents like Nokia, Motorola, and RIM—and a brilliant act of creative construction. In 2007, the year Apple launched the iPhone, the company was no spring chicken: it was thirty years old. And it was no minnow either. Its sales of $24.6 billion put it at number 123 on the Fortune 500.¹²

Amazon is another contemporary example of a huge company invading other industries. There are really two Amazon stories. The first is the classic start-up. This was the story of how Amazon.com brought us into the world of online shopping, at the expense of just about every brick-and-mortar retailer. The second story, though, is one of a still-young but relatively large company, which has continued to succeed at transformational innovation. In 2004, Amazon introduced one of the first cloud-based computing services and launched the cloud computing revolution. This represented a major business model innovation for Amazon, as selling web services is completely different from being an online retail business. Amazon’s revenues that year were $5.2 billion, and the company ranked number 342 on the Fortune 500.¹³ Amazon might have been young, but it was not small by any standard. Today, Amazon is a $178 billion company, and it continues to innovate and experiment with new businesses such as video streaming, content production, drone delivery, groceries, and health care.¹⁴

Today, we see a number of large companies actively engaged in potentially transformative innovation. Alphabet (formerly known as Google) is a $90 billion enterprise (ranked number 27 on the Fortune 500).¹⁵ It dominates Internet advertising, of course, but it has also been a pioneer in autonomous vehicles. Honda, a giant auto company, is attempting to transform the corporate jet market by developing a low-cost, lightweight jet that can efficiently serve as an “air taxi.” It is too early to say whether these businesses will succeed, but they are certainly trying. If large enterprises are not supposed to pursue transformative innovation, it looks like these folks never got the memo.

These examples—and probably many more you can think of—provide something akin to an “existence proof” that scale alone is not a showstopper when it comes to transformative innovation. But just because something is possible does not mean it is easy, either. It’s not. Innovating at scale takes work—work that is dependent upon thoughtful strategies and significant efforts that are distinct from those that tend to succeed in small enterprises.

The Challenge of Creative Construction