Filling the Innovation Gap

by Paul McNabb

There is a very lively debate running on Seeking Alpha about the pro’s and cons of IBM’s business strategy. See for example:

http://seekingalpha.com/article/3456146-ibms-21st-century-transition-is-failing

and it’s rebuttal:

http://seekingalpha.com/article/3472836-on-ibms-21st-century-transition-failing

 

However, one thing is clear – the market found IBM’s last earnings results disappointing as for the 13th straight quarter revenues declined. The company has long had a clear plan to exit low margin (principally hardware) businesses and invest in high margin (principally services and software) businesses that is considered a model of clarity and sound strategy. Indeed, although last period there were issues around emerging markets and asset disposals, the high growth businesses delivered a good performance. But the fact remains customers continue to buy less from IBM, quarter after quarter.

 

Of course picking on IBM is unfair as most of the old B2B IT companies exhibit similar behavior – Cisco, Microsoft, HP to name a few. When I worked in corporate strategy we tracked the largest IT companies and, as a group, revenues were trending down with a shift to a services and software business mix. But someone’s pain is somebody else’s gain – and within a slowly rising overall IT budget spend, the revenue loss of large historical suppliers is balanced by growth in sectors like Cloud/SaaS, security, external services and a whole variety of software plays.

 

Clearly, what is happening here are a series of major technology shifts, the leaders of the last race are not turning out to be leading the next. Scott Kupor at a16z wrote a very interesting post on this:

http://a16z.com/2014/10/14/what-all-the-recent-tech-company-splits-say-about-the-future-of-cloud-computing/

Good news indeed for the venture world that is actively backing these businesses.

 

Why is it playing out like this and what are the implications for investors and entrepreneurs? Why is innovation not coming from what are by any measure some of the most successful companies in history? They certainly understand what is going on in the market – they have internal strategy, M&A and marketing teams that are extremely well informed. They also have plenty of great people – smart engineers, dynamic sales champions and charismatic business leaders. And they often create the raw research in their own labs– many of the next wave of B2B players are of course started by former engineers at these companies. In general I believe it to be a facile and lazy criticism of these companies to say they just don’t get what is happening.

 

Instead I think there are two things going on – I call them the law of large numbers and the curse of the installed base. The first is what happens when growth stops or slows. If you are running a $50 – $100bn enterprise, and growth has stalled or is in the low single digits, all of a sudden your challenge shifts from managing the P&L to managing the balance sheet. Large high-margin businesses kick off a lot of cash – and typically far fewer good ideas as to what to do with it. Typically this initially leads to a number of poorly thought through “strategic acquisitions” to reignite growth which largely disappoint. Shareholders grumble, activism starts to play a part at AGMs and earnings calls, the CFO and the finance team are asked by the CEO to take the lead in planning and before you know it you are a value stock, talking up dividends and stock buybacks.

 

The second point is the adverse affect of all that historical sales growth – successful B2B companies have a huge installed base of product and users that they have no financial or operational incentive to disrupt. Think of IBM and Windows or Office, Cisco’s routing or switching franchise, or HP and servers. It’s the gift that keeps on giving – product refresh cycles and lucrative support and service contracts. Then there are the human causes of inertia. Sales people – and surprisingly often customers also – have grown up on the same product line, and don’t see the need for change. And if you are an engineering leader, why would you leave a huge business with a big team, for something you are told is strategic, but is risky and certainly unlikely to be a large enough business to accelerate your career internally. Risk outweighs return.

 

These two effects reinforce each other – the logic of financial discipline starves funds for internal innovation. It leads to tighter planning requirements, more demanding margin goals and “pivots to strategic businesses” – often a euphemism for lay-offs. In return this means the best career opportunities and biggest rewards are to be found in the existing businesses generating the cash. I’ve seen more than one high-potential innovation stifled by having to perform like a 25 year-old multi billion dollar business. Altogether, this discourages risk taking, drives away creative people, and stifles innovation and new ideas. It’s bad enough that technology innovation is moving at breakneck speed without large corporations being organizationally biased against success.

 

And that leads to the question of what do you do if you are IBM and struggle to innovate internally? You know what the market needs, and you have huge distribution channels and incredible customer relationships. And the answer is you increasingly buy innovation. You outsource it. You become a platform for other people’s great ideas. Statistics support this – data I saw recently from Pitchbook showed that the value of venture backed acquisitions by corporates more than doubled in 2014. In addition, data clearly shows corporate interest in early stage investment is increasing valuations, while the number of corporate backed accelerators seems to be, well, accelerating.

 

This is good news if you are an entrepreneur. You have more sources of funds, support, and more exit options. If you think your eventual exit may be to a large corporate, you should make sure you are getting good advice along the way from investors who understand how to play that game. For funds it is more nuanced – greater corporate participation in early stage capital means higher valuations and arguably more competition. On the other hand, played correctly it means greater opportunities for partnership. CVC can co-invest, help nurture important strategic relationships and skillsets – and of course also be a potential exit.

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