19 Sep 2012  Research & Ideas

Book Excerpt: “The Architecture of Innovation”

In his new book, The Architecture of Innovation, Josh Lerner explores flaws in how corporations fund R&D. This excerpt discusses the corporate venturing model and how incentive schemes make it successful.

 

The key to managing innovation starts, and probably ends, with incentives. In his new book, The Architecture of Innovation: The Economics of Creative Organizations, Harvard Business School Professor Josh Lerner puts it this way: "After too many board meetings in which the corporate investor parks his Fiesta next to the independent venture capitalists' Ferraris, the temptation to go elsewhere becomes too great."

In other words, companies who create internal venture teams to fuel their research and development must not cheap out when it comes time to reward their "intrapreneurs." In this excerpt, Lerner discusses the pluses and minuses of compensation schemes.

Read an interview with the author

R&D, Meet VC

From The Architecture of Innovation

By Josh Lerner

The Architecture of InnovationThe failure to offer adequate compensation to corporate venturing groups also mirrors the challenges that corporations face when rewarding innovators within their labs. For instance, when Lilly Ventures was hit by its initial wave of defections, it benchmarked its compensation levels against those of independent firms. The conclusion was that only the most junior staff were being rewarded at near a market level. Yet the corporation's senior management and human resource professionals resisted changing the scheme, pointing out the high quality of junior hires that the firm was making. It was not until 2009 that the firm's management agreed to the restructuring.

In some cases, rich rewards for corporate venture investors are not needed. For most of its history, Intel's fund has emphasized making passive investments in a wide variety of companies in selected categories, analogous to a mutual fund following an index fund approach. Such a program may place much less of a premium on the skills of the investment team, and the rewards can be scaled down accordingly.

"One frequent manifestation of these confused objectives is a difficulty in killing projects"

But in most programs, the demands on the corporate venturing team are considerable. These investors are asked to carefully assess portfolio firms, attend board meetings, and provide strategic guidance, just like independent venture capitalists. In some respects, their job may be easier: typically, the corporation provides all the funds, sparing them from having to undertake the arduous quest for capital. But in other respects, their jobs are considerably harder. Not only are corporate venture investors responsible for managing the tricky interface between entrepreneurial firms and an often slow-moving corporation, but they are also typically asked to be their firms' ambassadors to the venture community.

The many corporations that have eschewed incentive compensation have had to face a steady stream of defections once the junior investors have mastered the venture process. After too many board meetings in which the corporate investor parks his Fiesta next to the independent venture capitalists' Ferraris, the temptation to go elsewhere becomes too great. The corporation, having borne the cost of training the fledgling venture investor, does not get to benefit from the harvest.

These issues also manifest themselves when it comes to rewarding the managers of spun-out firms. Often, firms resist granting substantial equity stakes to these corporate entrepreneurs. Even more troubling, all too frequently the management teams are pushed to accept sketchily defined "shadow equity" rather than a real claim on the new entity. Much of the corporate resistance stems from the fact that their entrepreneurs are commercializing a technology that belongs to the company. This attitude is shortsighted, as it neglects the fact that there is typically a long road between a promising technology and a viable product. Without an adequate share of the upside, corporate entrepreneurs are often tempted to look elsewhere.

Many of the programs with the greatest stability—in terms of both management team and mission—have been characterized by high-powered incentives. An example is SmithKline Beecham's S.R. One, which operated under a single head, Peter Sears, from 1985 to 1999. Not only was the management team stable, but the fund achieved impressive successes. For instance, it invested in biotech firms like Amgen, Cephalon, and Sepracor, and coinvested with major venture firms such as Kleiner Perkins and New Enterprise Associates. Its compensation scheme played a large role in this success. During most of this period, the corporate venture capitalists received 15 percent of the profits they generated, as well as a bonus based on less-tangible benefits to the corporation, which could run as high as another 5 percent of the fund's capital gains. This approach kept SmithKline's venture investors sensitive to both its financial objectives and the parent company's strategic needs.

"In most programs, the demands on the corporate venturing team are considerable"

The large-sample evidence also suggests that these incentives really do matter. Gary Dushnitsky and Zur Shapira survey corporate venture groups to understand the incentive schemes they employ and then relate these to their investment behavior. The groups with higher-powered incentives are more likely to undertake investing akin to traditional venture funds—for instance, investing in earlier-stage companies. Moreover, the better-incentivized groups are more likely to have exited their transactions through an IPO or acquisition.

Incentive schemes may lead to changes in the corporate investors' behavior, as the authors argue. Or it may be that firms—anticipating that their program will require intensive involvement by investors—attract such venture capitalists by offering these kinds of incentives.

(It would be hard for them to definitively answer this unless they had been able to find a broad-minded company who would be willing to let them run experiments with their venture groups' pay schemes over the next decade or so.) But in any case, a strong link between incentives and performance seems to be present.

Reprinted by permission of Harvard Business Review Press. Excerpted from The Architecture of Innovation: The Economics of Creative Organizations. Copyright 2012 Harvard Business Publishing Corporation. All rights reserved.

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    • Viktor O. Ledenyov, Ukraine

    Let me agree that the design of compensation schemes for the innovation leaders within the R&D centers and departments at corporations represent a most challenging problem to consider in the time of globalization.

    Viktor O. Ledenyov, Ukraine