Angie, the Finance Director, is not impressed with Leslie's numbers. She refuses to invest in the innovation project because the Return On Investment (i.e., ROI) numbers don't meet the company's hurdle rates. The rest of the executive board members join her in voting against investing in the innovation project.
Leslie and his team are disappointed by the decision and wonder how they can get reliable ROI numbers for a product or service that still needs to be created. The team is stuck in a paradoxical business quandary. They live in a different world from the one their executive board lives in, and the innovation team lives in Explore, whereas the executive board lives in Exploit.
Explore — Exploit
Of course, leaders want to get returns from their investments in innovation, and it is similarly vital for innovation teams to recognize their role in creating value for their organizations. The challenge is knowing how to measure or anticipate returns from value propositions that don't yet exist and business models the company has never worked on.
I once met with Ben, the CEO of a European oil and gas company. His innovation team had been working on various projects, and he was keen to support their work. However, he admitted he needed help convincing his CFO to invest in innovation projects because the level of returns and time horizon for getting them was always fuzzy. Like Angie, Ben's CFO was also looking for concrete reliable numbers.
In such conversations, I have found that the best starting point is to help executives understand that there are two worlds in which their decision-making takes place (i.e., Explore and Exploit):
- In the Exploit world, Leaders deal with the current successful business. Although there are some challenges, they have solved the central questions around the business model. The company knows who the customers are, why they like the product or service, and how much they are willing to pay. They have also figured out how to create a value proposition, reach customers, and profitably deliver value. The level of uncertainty is low. Therefore, the main goal is to execute and grow this business.
- Leaders deal with value propositions and business models that have yet to be launched in the Explore world. At the beginning of most innovation projects, outstanding questions must be answered. The company still determines who the customers are and whether the value proposition will resonate with them, so they would be willing to pay for it. The company still needs to figure out how to create and deliver the value proposition to customers. The level of uncertainty is high. Therefore, the main goal is to identify a suitable business model.
Given these two worlds, the financial philosophy for making investment decisions has to be different. Leaders must distinguish between the ROI they expect from individual innovation projects and the ROI from a portfolio of innovation projects.
Exploit = Return On Investment
When the level of uncertainty is low, the financial philosophy is about having steady returns and dividends. With Exploit projects, it is reasonable to expect that teams will have the data necessary to complete the formula for calculating ROI.
With a successful business model, teams should be able to predict the net income and investment cost. This may not be 100% accurate, but the approximations should be close enough. It is, therefore, reasonable for leaders to base their investment decisions on the expected ROI for each project within an innovation portfolio.
The portfolio management team at Sealed Air, a package manufacturing company in the United States, does this well. The team identifies some of their Exploit projects as Line Extensions. These are improvements to existing packaging at the request of specific customers. In such a situation, uncertainty is relatively low, and the teams can calculate the expected ROI from these projects. The portfolio managers then track whether the ROI numbers have been met after completing the projects.
Explore = Return On Portfolio
When the level of uncertainty is high, the financial philosophy is about venture capital-style risk-taking and accepting failure while expecting a few outsized winners. With Explore projects, innovation teams need to have all the data necessary for completing the formula for calculating ROI at the idea level. This data must be gathered through experimentation and testing of the business idea.
The best way to invest in Explore projects is to use metered funding. Leaders initially make small investments in multiple ideas. Over time, they can increase their investments in pictures that show progress and traction. Projects that need to make progress based on evidence can be stopped.
When using metered funding, leaders must base their investment decisions on something other than each project's expected ROI. This is because they expect some of the projects they invest in to fail. The goal is to recoup these losses and make high returns on the few successful projects. So the rate of return has to be calculated based on the entire portfolio of projects (i.e., Return On Portfolio).
Bayer's Catalyst Fund was run like a venture fund, but internal teams made the investments. Over three years, they received 400 proposals from which they chose 74 projects to receive an initial €10,000 each in funding. After testing their business ideas, only 29 projects were selected for the program's next phase and received a grant of €90,000 each. After this phase, 17 projects successfully showed feasibility and viability. The business then continued these with a further investment of €100,000 – €300,000.
Bayer's innovation portfolio is expected to produce up to €1Bn in annual revenue, far exceeding the amount of money they invested in the portfolio. The revenues from the 17 successful projects will cover the investment made in the portfolio of 74 projects while also providing a healthy return. Interestingly, over 60% of these returns are driven by only 3 of the 17 highly successful projects. This pattern of returns is quite similar to venture capital funds that invest in startups.
As a general rule of thumb, a successful innovation portfolio can be expected to produce at least 10X returns in revenues. These returns will depend on the industry, the size of the market, and other factors. But it can be used as a general rule of thumb for evaluating the success of an innovation portfolio.
The time horizon of returns
Leaders are also interested in the time horizon for getting returns from their investments in innovation. In general, the time horizons for Exploit projects are faster than the time horizons for Explore projects. However, it is helpful to distinguish among the three types of innovation when talking about time horizons for returns (i.e., efficiency, sustaining, and transformative).
- Efficiency Innovation focuses on improving the core business. Typical examples include technologies that generally improve operations, distribution, or processes, and they may also have process innovations that help make an organization more effective. Leaders can expect to see returns on their investments within one year.
- Sustaining innovation explores opportunities that build on a company's existing business model. This is typically about new products and services for existing customers, and they may also involve new distribution channels, production technologies, or geographical expansion. Leaders can expect to see investment returns within 1 - 2 years.
- Transformative innovation helps a company create substantial growth from radically new opportunities. This typically involves exploring new value propositions or business models. Leaders can expect to see investment returns within 3 - 5 years.
A final thought
Explore innovation projects don't have to be a black box. After making the initial investment, leaders can track a team's progress using tools such as the Innovation Project Scorecard. This tool helps leaders evaluate how much evidence exists to support ongoing investment in innovative ideas. All other investment decisions are then based on evidence.
Contemporary organizations need ambidextrous leaders who are world-class at leading in the Explore and Exploit worlds. For every investment decision, the leadership skill is to identify what world the project is in, set the right expectations in terms of ROI and ask the right questions at the right time.
- Leaders want to get returns from their investments in innovation. Similarly, innovation teams have a role in creating value for their organizations.
- Leaders and teams need help knowing how to measure or anticipate returns from value propositions that still need to be created and business models the company has never worked on.
- It can be helpful for leaders and teams to understand that there are two different worlds in which their decision-making takes place.
- In the Exploit world, leaders are dealing with the current successful business. The level of uncertainty is low. Therefore, the main goal is to execute and grow this business.
- In the Explore world, leaders are dealing with new value propositions and business models that are yet to be launched successfully. The level of uncertainty is high. Therefore, the main goal is to search for and find a suitable business model.
- In the Exploit world, the financial philosophy is about having steady returns and dividends, and teams will have the data necessary to calculate ROI. Therefore, it is reasonable for leaders to base their investment decisions on the expected ROI for each project.
- In the Explore world, leaders cannot pick the winning ideas on day one. The financial philosophy concerns venture capital-style risk-taking and accepting failure while expecting a few outsized winners. So the rate of return has to be calculated based on the entire portfolio of projects (i.e., Return On Portfolio).
- In general, the time horizons for Exploit projects are faster than the time horizons for Explore projects. We can also distinguish among the three types of innovation when talking about time horizons for returns:
- Efficiency Innovation: Leaders can expect to see investment returns within one year.
- Sustaining Innovation: Leaders can expect investment returns within 1 - 2 years.
- Transformative Innovation: Leaders can expect to see investment returns within 3 - 5 years.
For every investment decision, the leadership skill is to identify what world the project is in, set the right expectations in terms of ROI and ask the right questions at the right time.