Awaken the Valley Within

CFOs must learn how to foster innovation, says strategy guru Gary Hamel, and Silicon Valley provides the model.
A CFO InterviewSeptember 1, 2000

Six years ago, at the height of the reengineering revolution, Gary Hamel and C.K. Prahalad informed Corporate America that it was headed in the wrong direction. In Competing for the Future–perhaps the most influential book on strategy of the 1990s– they argued that innovation, not efficiency, was the path to greatness. The goal, in a nutshell, was to get to the future before anyone else did. Only by creating new businesses, and reinventing existing ones, could companies become dominant market leaders.

Today, Gary Hamel has a new book on strategy for a new, dot-com decade. In Leading the Revolution, the 45-year-old management consultant urges companies to “go nonlinear” and create not just new products and services, but also new business concepts capable of producing enormous wealth. Innovation, Hamel proclaims, is too important to be left to the visionaries. Like quality, innovation should be everybody’s responsibility, systematically fomented throughout the workforce.

What’s more, says Hamel, Silicon Valley shows us how the future can be conceived and financed. Venture capitalists keep an eye out not for the incremental sure thing, but for the billion-dollar new thing. They nurture portfolios of projects, and they don’t demand high probabilities of success. They fund ventures in small, rapid stages and are ready to scale up investments at a moment’s notice.

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All this is foreign to the capital budgeting process at most companies, says Hamel. Is the traditional finance function the enemy of change? Do CFOs need to become more like VCs? Last July, CFO New York bureau chief S.L. Mintz posed these questions and others to Hamel in the Menlo Park, California, office of Hamel’s consulting firm, Strategos.

What have you been helping your clients with lately?
A lot of what we’ve been doing in some very substantial companies is creating new mechanisms for resource attraction. How do you re- create some of the wealth creation, energy, and passion inside of a company that you see in Silicon Valley?

There is a distinction between resource attraction and resource allocation. In most companies, one of the critical roles of the CFO is allocating resources across businesses, projects, and so on. That process works pretty much like it worked in the old Soviet Union, in that somebody has an idea and you have to fight that idea up through levels of uncomprehending management.

If you look at the way Silicon Valley works, there is no giant brain or CFO of Silicon Valley saying, “We’re going to put this much money in this sector and that sector.” Somebody throws out an idea, it gets considered by all sorts of sources of capital. If the idea has merit, it attracts capital and talent. If it doesn’t, it just dies.

I sense a thinly veiled hostility to CFOs in Leading the Revolution. For example, you write, “The next time you’re thinking about how to turn the world upside-down and someone asks you for an NPV, take a minute to educate them on the difference between a strategy conversation and an operational conversation. Then tell ’em to cut you some slack.” Elsewhere you say, “Venture capitalists are not financially stupid people, but they sure don’t think like CFOs.” You seem to be using CFOs as an emblem of people who aren’t open to ideas. Do you think that’s true?
I’m less trying to point a finger at CFOs than using them as a symbol for how we’ve managed large companies. Industrial Age companies are very, very good at efficiency, at diligence, at replication. What I’m trying to point out as kind of a thesis and antithesis is the distinction between Industrial Age companies and the kinds of companies that are going to be capable of surviving in this new world.

Today, a lot of wealth creation is driven by creativity, imagination, radical new business concepts, experimentation, self-organization, and complex networks of firms. And so almost everything that seems to be important now in the new economy is in some sense almost antithetical to what helped companies in the old economy.

Traditional financial controls are extremely valuable in driving inefficiency out of existing business models. I think they often get in the way of creating fundamentally new business models.

It sounds as if a CFO who’s doing his job in the 20th century is inimical to the interests of innovation.
I believe so. If you go to any CFO and ask, “Have you done a systematic review of your management processes to understand where and how they frustrate innovation? ” not 1 in 50 is going to say yes. Over the last decade, just about every company I know tore apart most of its core business processes to try to make them more efficient. The issue going forward is reengineering management processes for innovation. I think it’s going to be every bit as hard work as reengineering our supply chains.

How do you institutionalize innovation?
The analogy I would use is this. If you went back to the mid- 1950s and asked someone where quality came from, they would have said either the artisan or the inspector. Either it was the person on [Savile Row] that made you a beautiful handmade suit, or it was the inspector at the end of the Mercedes production line– the guy in the white lab coat.

Then Dr. W. Edward Deming came along, and he said, Why don’t we make quality everybody’s job? I remember him sitting in one American car company, saying to the senior team: “We are going to take people that have a maximum 12 years of education, with grease under their fingernails, and we’re going to teach them statistical process control. And we’re going to teach them Pareto analysis, and we’re going to give them responsibility for stopping billion-dollar production lines.” People literally thought he was nuts.

The issue now is innovation, not quality. Today, if you ask people where a radical new wealth- creating idea comes from, they’re going to give you an answer that is equivalent to saying that quality comes from the artisan. They’re going to tell you it comes from the visionary. But most companies are not led by visionaries, and in those that are, the visionary will typically kill the company, because when you come to the end of the visionary’s headlights, you just crash and burn.

We have to do the same thing for innovation that we did for quality. We are not talking about a few brainstorming sessions or suggestion boxes. We are going to have to challenge our deepest beliefs about the role of top management, about how big companies work, about the balance between stewardship and entrepreneurship.

Which companies understand this and are doing something about it?
There’s one reasonably large consumer durables company, with about $12 billion a year in revenue, that has decided that for the next five years, each year they’re going to take an additional 10 percent of their capital budget and devote it to projects that qualify as radical. And radical meaning one of two things: either projects that are aimed at a discontinuous change in an existing parameter of competitiveness–so something that says we’re going to take an additional 10 percent of cost out would not qualify as radical, something that says we’ll take 90 percent of the cost out would qualify–or projects that are aimed at creating entirely new parameters of competitive advantage.

The goal is to put at the end of the five years fully 50 percent of the capital budgeting into these radical projects. What they’re essentially saying to all of their divisional executives is, “We will starve you of capital unless you come to us with projects that are radical. And the reason is because what investors want today is interesting stories about growth, new markets, and new possibilities.”

Are there other companies?
Royal Dutch/Shell is one I’ve written about. Both Shell U.S. and Shell worldwide have created a new kind of capital allocation process– or I should say a resource attraction process. In the first year, they set aside $20 million and invited proposals from anywhere in the company for things that could turn out to be new businesses, and things that were simply new technologies in existing businesses. The people allocating this capital were a team of fairly young people, all known to be kind of radicals and creative types.

Are you saying to take the CFO out of the process, and ideas will proceed faster?
It’s not about an individual, it’s about the criteria. There is a set of opportunities any company has that simply won’t make it through the traditional financial screens, because they start with different assumptions, or they don’t draw on the traditional wisdom, perhaps, of the company, or because the uncertainties are too high.

Many companies look at every project as a single project. Every project has to deliver value on its own merits. What happens over time is that the bar goes up, and you need to convince me with something around 90 percent probability that a new idea will succeed. There are all kinds of ideas there that are 90 percent sure things. But there are very few ideas that have the potential for creating enormous new wealth that are sure things.

Venture capitalists never look at a project as a [single] project. They always look at a project as a portfolio project. The average investment of a venture capitalist has probably about a 20 percent chance of success. They know that out of 10 of these, 7 or 8 of them I lose everything, 1 I double my money–which is as bad as losing everything for a venture capitalist–and 1 of them is like Hotmail: I put in $300,000 and I get back $100 million.

Now, if I go through the usual financial screening process in a large company and I say I have this really great idea, but there’s an 80 percent chance that we’re going to lose every dime we put in this thing- -they’ll just laugh at me.

But can you run a Fortune 500 company the way a venture capitalist operates?
The goal is not to turn Fortune 500 companies into venture capital companies. I believe we are heading for a synthesis between these two models.

Let me give you an example. Enron has an incredible track record of creating bold new businesses built on radical new business models. They did it when they pushed natural-gas deregulation in this country. They did it when they created EnronOnline, which today is the single largest online business in the world. It does more than $500 million of transactions a day. They did it when they created Enron Energy Services, which outsources energy. They did it when they moved into the market for selling broadband.

Now, Enron has achieved this almost magical mix of entrepreneurship inside with the ability to leverage enormous scale and discipline to get things done. There is not a dot-com in the world that could have accomplished what Enron did [with EnronOnline]. Trading energy is enormously complex; there are hundreds of pages of contractual fulfillment on any transaction. And Enron did this in less than a year from a standing start, and it started with a 29-year-old woman on a gas trading desk in London. In fact, the system was two months from going live before they told the chief executive and chairman what they were up to.

Was the CFO standing in the way?
No, he wasn’t. I think the role of the CFO is more and more how you create the climate in which all of this can happen. But it’s not to be the judge and jury on the quality of individual ideas.

The thinking that goes on in finance, and behind the capital- budgeting process in large companies, is a basic assumption that every investment is going to be largely incremental to existing businesses. It’s there to build new distribution infrastructure, new IT systems, and so on, number one. And number two, the increments of investment will be fairly large.

What most companies are not set up to do is to make a series of extremely rapid, very small investments as you slowly accumulate learning and scale something up. To give you an example, at Idealab, which is probably the premier Internet incubator in the country, a first- stage experiment is usually under $50,000. The second stage would be $250,000, and so on.

There is a way to deal with that kind of staged investment: real options. Is real-options theory consistent with what you propose?
I think it’s consistent. You’re not going to find very many venture capitalists who worry about real options. But the theory is absolutely the way they think.

When I talk to CFOs about these issues, a common objection I get is this: “You’re saying that we’re going to let a thousand flowers bloom and something ultimately comes out of this. But we’re a big company, and investors are never going to notice some tiny little thing.”

That’s a fair point. Nobody is going to notice a $20 million thing in a $30 billion company. But this is what I come back with: There are somewhere between 40 and 50 companies right now in the United States that have a market capitalization of more than $5 billion with current revenues of less than $100 million. Almost all of them are less than four or five years old. So I say, is $5 billion big enough?

How many experiments had to get started in the Valley to get one of those $5 billion things? My basic rule of thumb is this: Out of 1,000 ideas, something less than 100 of them will be worth a first-stage, low-cost experiment. Out of those 100 experiments, something less than 10 will give enough positive feedback to say, Let’s really put in some capital. Out of those 10, maybe 1 or 2 of them ends up as a new, $5 billion thing.

Most of the traditional financial apparatus is not set up to support this kind of a process. When you start a new thing, you can’t wait until the end of the quarter to decide whether to kill it or ramp it up. You are making decisions in real time.

Somewhere in all this, it’s almost as if you’re beginning to describe a new role for the CFO.
One way of thinking about it is that the CFO becomes the internal venture capitalist. A venture capitalist asks different kinds of questions, plays a mentoring role, and is incredibly close to the ventures they’re interested in and they’ve invested in. Again, I want to be clear. It’s not all one or the other. It’s a synthesis of both old and new economy. The [finance] function is always going to be critical, and always going to be central.

Given your observation that revolutions don’t start with a monarchy, and given the fact that CFOs are in effect royalty, you’re not looking to them to be creative engines, but rather to learn how to foster innovation within the firm?
Let me put it this way. CFOs are on the critical path of any transformation of a company, from old economy to new economy. Forget radical innovation. If CFOs just focus truly and genuinely on the challenge of creating new wealth, I think their role will change enormously.

Think about this. We live in a world in which the way you create wealth is variety. You try new things. Well, the whole core principle in finance is that variance is a bad thing–variance from a budget, from a plan. That kind of thinking slowly permeates everything, and people begin to manage to the budget rather than manage to the opportunity.

I think it would be interesting if every CFO had to do a three-month sabbatical in Silicon Valley. And of course, every CFO of a little Silicon Valley company needs to do a sabbatical inside of a large company as well. We’ve got to learn from each other.