Why ROI is the only thing that matters in innovation

Today's session is going to be on why ROI is the only thing that matters in innovation. The reason why we thought this was, would be a great, great topic to have a conversation around is because what we often see is that innovators try and skate from being asked this question about what is the return on investments in the innovations that they, that, that they're working on. It's a, it's a topic people try and avoid having a conversation about. And so we thought it would be really wonderful because ultimately all the innovations that we work on, well, not every single one, but the investments that we make in innovations should produce some return.

I'm going to go back to something we talk about a lot and you've probably seen me present about the Explore Exploit spectrum. But here it's incredibly important and one of the things that we just published, actually an insight paper on the dual mindset organization that you're able to do these two things at the same time. So you know, everything starts with an idea. It could be a startup idea, could be an improvement of your business model. It starts with an idea. Then of course we search for the right business model or value proposition or simply solution. Then once we found it, we scale and we manage that. That's the kind of exploit world we know. The world on the left hand side is messy, so it will require different way of investing and a different way of measuring return. This is what we call the Explore exploit spectrum and you've heard us talk a lot about it. But let's just get back to the reminder here. There are three things that are important to look at. The first one is to clearly understand uncertainty is different. If in the exploit world, we know the customers, we know the business model, we can plan and we can execute and then do the traditional return with a business plan on the left hand side. It's very unpredictable. So you can't plan and execute. You need to iterate fast. What that also means is that we invest differently. On the right hand side, you make large bets into proven areas or arenas, you improve your processes, you strengthen the sales force with an efficiency innovation. But on the left hand side that's very different. We make the small investments in a lot of ideas and then we only double down on those ideas that work. So you'll see that the return on investment is actually return on portfolio. So you're going to look at the many ideas you invested in and only the few that emerge because you don't pick the best ideas and teams. They emerge and then the last one and here's where it really gets interesting and where we're going to frame it around different type of return on investment. The leadership style changes. You need to on the right hand side, as a manager, execution leader, you ask what's the plan? Are we on time, on budget? Now the same leader, potentially, if you're the CEO, same person on the left hand side will have to switch. That's why we call dual mindset. Not just dual, you know, organization, dual mindset, organization. You ask different questions, are we on plan, on time, etc. Is the wrong question. What did we learn? Is it worth continuing to pursue the idea, the project, or should we kill it or should we change it? That's extremely important. And all the things change, not just the process, but also the metrics. So we'll see. How do we measure return on investment on this side and how do we measure return on investment on this side? And if you don't measure return on investment on both sides, well, you're not going to get the best out of your work.

And that tends to happen is when leaders are measuring ROI from the investments in innovation, they really know that that's the ultimate measure of success. So they want to focus on the, on the ultimate measure of success. But really what we want is shifting from focusing on return on just the project and doing a return on portfolio. And what that does is it helps us avoid making excuses as innovators in terms of not wanting to measure roi. The way to think about this is to go back to the framing that Alex used and again go from explore to exploit and think about the three types of innovation. So we have efficiency innovations where we're improving our processes and existing business models and just refining our current value propositions. And then we have sustaining innovations where we might create new value propositions or extend existing value propositions, turn into new channels and new geographies. And then we have our transformative innovations where it's completely new business models and value propositions, entirely new growth engines in spaces we've never actually played before. Now, how we calculate ROI is impacted by, by the type of innovation that we're working on. If you're on the exploit side on the exploit extreme of that dimensions, you can calculate ROI using the basic calculation of net income divided by cost of investment times 100, because you do have the numbers and mathematics to actually do that calculation. But as you get to the more innovative, transformative innovation side, you actually need to use a different framing. And one way to look at this is to think about if you're doing efficiency innovations, it is reasonable to expect that every single thing you invest in becomes successful. Now, of course, there's a spectrum. It's not that every single efficiency innovation succeeds, but leaders have a right to demand that from us because we're working with known customers, known value propositions, known channels, known revenue past. We're looking at, we have all the numbers to be able to actually make that calculation. We're not guessing. So here in this visual where like, you know, you make one bet, you expect to succeed with that, with that one bet, of course you fail. So it's like a range, you can also think about it as two to one. Maybe, you know, you make five investments in efficiency innovation, you get three as a successful outcome. But the success rate of investing in efficiency innovations is higher than the success rate of investing in other types of innovations and should be higher because we're dealing with a lot of things that we, we kind of know about. But as we move across the spectrum to sustaining innovations now, because now we're like maybe creating new value propositions or trying to enter new channels and new geographies now, the amount of risk goes up a bit from efficiency innovation is not the same level of risk as transformative innovation. But in that case, you can expect to make 10 bets, right? And maybe, you know, in the early stages, you, you, you kill four of those bets because you, and then you're left with six, and then you get to four bets, and then ultimately you scale three of those. So you can expect, you know, 30 to 40% of the, of the bets you're making to become, to, to become successful as you're working on sustaining innovations. But when it comes to transformative innovations, the situation gets a little bit more. You need to make more bets in order, in order to find things, to actually find things that work. So you can make maybe 100 bets in order to find even 10 things that become successful. Go ahead, Alex. I can see you. You want, you want to say something?

Yeah. No, because we use this rule of thumb of 10 and we didn't want to get too extreme to scare people off, but in a large established organization, it'd be more like, you know, we could go way more aggressive and go 100 to 2. Because in the venture capital world, if you look at early stage venture capital, there are statistics that clearly show it's 250 to 1 to get a 50x return on capital. So that's not even revenue, right? So we need to start to get more bold. And we use the rule 10 to 1 just so we can get companies started, but the reality would be way more aggressive. And then we could say, okay, it's a little bit different because you have IP, you have customers, etc. But I do think we want to push that. 10 to 1 is very conservative still.

Yeah. And is, is very conservative. And also 10 to 1 works if your goal is to get 10 times returns rather than 50 times return. So if you also like, lower the ambition of the returns you want to get from your transformative innovation, you can, you can, you can use a kind of a different ratio there. But if you do want to get 50 times return, you have to be making many more bets and expecting, you know, a small number of those to give you, to give you that level of return. So what that means is that when you're working on Explore innovation, you cannot use ROI on a per project basis to make decisions about whether or not innovation is succeeding. What you really need to be measuring and tracking is return on portfolio. So if you look at the screen here with Bayer, for example, they invested in 400. Sorry, they had 400 ideas submitted, then they invested in 74 ideas and only 17 of those ended up becoming, you know, businesses that became successful. So the question for them is not what happened to the 75th idea or what ROI did we get on the 73rd idea. The question for them is, after making all of these investments, are the returns we're getting from the 17 that succeeded covering the cost of the multiple investments that we made and also giving us a return on, on those investments. So it's really a return on portfolio, a return on the capital we've deployed to run this entire process. And I know, Alex, you, you have an example of some of the calculations we did with some of our colleagues and, and Fred Koh.

Yeah. But before we move on, I think the interesting thing here, Bogdan made a report, a comment in the chat that this is, you know, something you can do before you get to transformative innovation. You first go with efficiency and sustaining. And that's a very important point. Henning Trill, who was leading this effort at Bayer at the time, did exactly that. He said, well, we're not going to go right away to transformative. That would be suicidal because we'll see afterwards the timeframe is much longer. We're going to get quick results. So what's really important for, for innovation leaders and for CEOs is to start with the quick wins. The CEOs usually ask for those, but you can't get those in transformative innovation Right. So you start with quick wins in efficiency, innovation and sustaining innovation to establish the process. But you already have a portfolio mix. Remember a couple of people where we had exactly this approach, some of our clients being smart enough to build up that trust. So incredibly, incredibly important. And what you were referring to, maybe just the last example, is a pharmaceutical company where we got to a 10x return on investment because they had, you know, this, this, this, this wisdom to diversify the portfolio in the right way. And in that case it was 50 ideas that they, 50 projects that they invested in. Right here the ideas are not tested. It's when they get projects so you can get to a 10x return. And in this case we're talking revenue and not just valuation like in the startup world. It's possible we have cases like that when the CEO is dedicated to making this happen.

Exactly. And, and, but, but, but the point to land is that, and this is a really, really important point to land, it's an important point of principle, which is we don't calculate the ROI on a per project basis because if we do that, we get stuck in this world where projects can't now fail. But if we're calculating return on portfolio, it means that the ones that become successful, as Jeff Bezos would say, pay for the multiple failures that we invest in.

And so that's now going into time horizons. So we looked a little bit about how many projects do you need to invest in? So more the, the ratio part low ratio in efficiency innovation because you know that world we're close to exploit high ratio in Explore now what about time horizons? When we are in efficiency innovation and sustaining innovation and transformative innovation, the time horizons are very different and that's why you need that mix. The way we look at it, if I get out of the way here a little bit, one year, one year when we talk about exploit is something, you know, one to two years maybe in that time frame you get very quick results. What's an efficiency innovation? Might be an app, you know, a new app for the salesforce or something around those lines or you know, improvement in your supply chain. You generally can get to those pretty quickly and you want to expect a return and remember, one investment, one return, so then the second one is somewhere like one to two plus years for sustaining innovation. New products can often get up to three years. Again, depends a little bit what it is. New channels, not doesn't happen right away, probably also around two to three years. And then when we're talking transformative innovation. So that was nice to See, we're all pretty aligned. It's not going to happen overnight. Right. And if we weren't really honest and put the big size there, it's probably closer to 10 years. But we also, you know, in the work we do, we don't want to scare senior leaders and CEOs away with unrealistic stuff for their careers. So we made it a little bit more approachable. But there's always a reality check. If you are in a large company want a large transformation, don't expect that to happen in three years. Here we're talking really about processes. Here we're really talking about new products, new channels, maybe new geographies. And here we're talking about completely different business models. Some might be disrupting, you know, for and cannibalizing the old business model, but not necessarily. Again, the example that everybody knows Amazon Web Services was not cannibalizing Amazon, the traditional E commerce business model. If you take marketplaces, it definitely did. Now the other thing, when we look at time horizons, so here we're going to get a little bit more sophisticated and obviously this is, you know, something that comes from our experience. This is not scientific data, if you want, so don't ask us for the sample set. But it is what we, what we see. So generally in efficiency innovation you go from zero to a lot very quickly, but it's not going to sustain the revenue growth for very long time. So the growth kind of goes back down. So don't expect from efficiency innovation to get something that's going to sustain you for 10 years. Now if we add to that the sustaining innovation, new products, maybe radically new channels, well, maybe it's a little bit harder to get off the ground, but it's going to really help us in the medium term. But also new products are going to have to be replaced with new products, right? So new products generally don't work for a very long time and often you're just replacing expiring revenues. When a car company launches a new car model, they generally don't get an insane amount of growth. They're just replacing the, the old car models, right? So it's hard to grow just by replacing old products with new ones. And now if you look at the last one here, when we talk about transformative innovation, it's more like the known hockey stick from the startup world is going to cost us quite a bit to test Valley of Death. And then it's going to take a bit longer until we get here, but it's going to sustain us for longer and it's much harder for competitors to catch up and compete against a new business model. I mean, think Salesforce, when they destroyed, you know, the old guard Siebel. And so as a startup now the question is, can established companies create these kind of transformative innovations? And if, again, if we take the usual suspect like a, like an Amazon, it can be done. Now Tendai, one of the things that you've been asked is, well, why would I as a CEO wait for so long to get this when I can get this immediately? So what was your answer, you know, when you got asked by the CEO of a relatively large company, you know, I want returns right away. If I invest in efficiency innovation, I get returns. Why would I wait for so many years until I get a return? How did you handle that question?

Yeah, no, it was a very fascinating question. And, and just in the, like in the, in, in the moment in the room, I just kind of got up and started drawing S curves. Right? And if you actually go back to that slide where you show the immediate investment returns, what we tend to notice is that if you invest in, in, in, in efficiency innovation, you do get the returns within a year or two, but then they don't actually keep growing and lasting that long. Right. You have to keep doing stuff to refresh that. Right? And so you can see that you get early returns that then decline over time, whereas, and, and with sustaining innovations, again, you get quick returns, but they decline over time, whereas with transformative innovations, you get small returns at the beginning that increase over time. And so you need a balanced portfolio that's making all three kinds of bets because that way you cover your bases, you get your immediate returns in some of your investments, you get your midterm returns on your intermediate investments, and you get your, your long term returns, which is something you're showing visually in this graph. You either have a small company that's only based on the investments in efficiency innovations, but if those efficiency innovations start to decline, or those, that efficiency portfolio starts to decline, you at least have the transformative portfolio to sort of take over that, over, you know, over time. And so balancing those S curves is really the role that innovate company leaders should be thinking about.

And I remember when we discussed this question before, you actually answered and that was something, you know, that we haven't really done in the same way at the time to actually argue when we intuitively we knew that this is the right thing to do, but we never had to draw it in this way. And this really, really resonates with leaders. So you start to calculate the return on investment on your portfolio. You'll get a fast return from the blue ones. You'll get a slightly longer and more substantial return on the green one. But if you really want to, you know, work for, for 5, 10, 20 years, look ahead and build a substantial business, you need to invest in, in transformative innovation. And if you don't do that, you will actually fall off a cliff. Right. And that is something that we see a lot of companies do they wait until it's almost too late or too late?

Exactly. And there's interesting questions that are coming up in the, in the, in the chat. So, for example, asking that the average tenure of a CEO may be less than five years. So what metrics do you, do you see work? But, and here's what I love about the logic that we're explaining here. We're not going to leaders and going, you're going to lose revenue for the next five years and then see revenue in year nine. We're actually providing them a way of having a balanced portfolio where they maintain and sustain existing value propositions. They're able to create adjacent or, you know, sustaining value propositions. Right. Which are the kind of the light blue ones and at the same time invest in the future. Because the Jeff Bezos story, which is I'm not going to be giving you returns for the next 10 years, that's a hard one for a lot of CEOs to sell in a lot of contexts, that's not going to resonate. But the notion of having a balanced portfolio where some of our investments give us early returns, some of our investments give us intermediate returns, and we're also investing in things that give us long term returns. I think that's an easy sort of, or maybe a less difficult conversation for CEO to have with their shareholders and investors.

And the thing I'd also bring up is what you can do when you start measuring your portfolio is you can actually put a portfolio value on this. So you don't need to wait 10 years. Because with the way we measure portfolios today, we can put, you know, a value on these, on these and on these. The more you're to the left to uncertainty, the more you put zero as a value, the more evidence you have is like in the sales funnel, as sales teams know this very well, right? They'll, they'll value this maybe at 80%. So if you have a billion dollar project that makes it all the way to the acceleration phase, you can actually say, well, the portfolio value today not materialize in terms of return on investment but the the potential value is around 800 million. Right. And you know reading McGrath's work around options and so is is really powerful there so you can get results by de risking already and the likelihood of these projects becoming real winners is large when you know how to manage a portfolio and this is something that we're getting really, really kind of rigid around. So you want the flexibility of the startup world with the rigor that's required from large scale investments in a corporation you can't afford not to measure this stuff. So we're really starting to get good at this. I think it's still early days but you need to measure reduction of risk and uncertainty, the risk of your portfolio but also the value. And then ultimately at the end the only thing that matters is the financial return which you'll get, you know, after two years or so all the way to the next 10 years.