4 Proposals on How to Make Companies More Innovative

‘So I said okay, this is outrageous this is a small, start-up 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. Those companies are fine in themselves but as Peter Thiel’s Venture Capital firm Founders Fund has glibly noted ‘We wanted flying cars, instead we got 140 characters.’ So the question becomes how do you make big companies more innovative? 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 and we shall try to argue here for four proposals that we think shall meaningfully change the incentive systems and corporate structures and in doing so incentivise more innovation.

First we propose that big companies should change their organisational structure from a hierarchial 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 which is good because such a career track tends to make employees very risk averse and much more focused on playing the ‘office politics game.’ This leads to the second advantage which is it would diversify the ideas that are brought to the table. The third advantage is that in hierarchial 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 of course is exactly what you don’t want when taking risks because 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 these two kinds of people 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 that 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 meaningful contribute to the strategic decision making in the firm. 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 corporate 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. As Peter Thiel has said ‘There is a strange phenonemon in Silicon Valley, many founders seem to have some kind of Asperger’s, are bad at understanding social cues. What it does say about our society when they are the innovators, and the normal people basically learn to conform?’ 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 innovative because they fail to unlock the creative talents of their employees. Everyone can innovate but they are just not given the opportunity to. We would argue that exactly the opposite is true because big companies suffer from an over democratization of power not a lack of it. If you look at the most innovative companies today like Google and SpaceX they tend to be start-ups where the founders have retained immense internal power to greenlight projects 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 is how the corporate hierarchy is structured but 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 where so short-term he has actually taken Dell private again arguing that ‘It certainly wasn’t an easy thing to go through the process (going private), once we’ve gotten through it it’s been a lot easier managing the business as a private entity. We can take on risk. We can accept risks and invest more aggressively.’ From a societal stand-point though having all companies go private is not the solution because the capital markets offer a valuable source of funding. The question is how can we have the benefits of the capital markets without the disadvantages? We think one solution might be to have an exchange where transaction costs are exhorbitantly high (say 10% of the value of the shares being traded) which would price out a lot of the short-term traders and the immense volatility (and short-termism) they bring to the market leaving only the long-term investors. Another solution might be to only allow stock trading once a year in a ‘transfer window’ although it is not clear to us whether this would really dampen out the volatilty and short-term incentives or amplify it.

Our fourth and final proposal is to more aggressively tranch the risks of investment over multiple stake-holders. As an example, it is very common in America for big infrastructure projects to be financed with public-private partnerships where 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, when Steve Jobs and Apple invested in developing the iPad it was a big risk that Apple bore alone. Understandably many companies that might want to develop similarly risk projects but dare not in case it fails. Perhaps one solution could be, to use the iPad example, that Apple would release a bond or a form of equity that allows investors to invest in the future returns of a specific product (the iPad) and in doing so tranch out some of the risk thus allowing companies to be more aggressive in their investments. Previously an investor who is very bullish on a tablet type device can only make the (much more general bet) of buying Apple shares. But the return on Apple shares is not just a function of the success of the iPad but other products like the iPod and iPhone which for an investor who wants to specifically bet on the iPad is diluting his investment. 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 the single most important problem that ‘Management’ as a discipline has to solve is how to make big companies 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, and instead actively change the incentive systems and corporate structure which big companies work under because in the words of Berkshire Hathaway’s Charlie Munger

‘Well 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.’