Organizational DNA, Disruptive Innovation, Economics at the Speed of Light and the Impact on Investment in Future

4 12 2010

Marye Anne Fox, National Medal of Science Winner (2010) and Walter Kohn, Nobel Prize in Chemistry Winner (1998) at a recent UCSD 50th Anniversary Celebration

Abstract:

The economics of communication, collaboration and commerce at the speed of light is changing the global competitive landscape by leveling the playing field in product leadership, operational excellence and customer intimacy through commoditization of technologies. The only choice open for nations to be number one is to bring disruptive innovation to differentiate.  Time and again, evolution has proven that architectural simplification through disruptive innovation brings orders of magnitude productivity. Life forms survive and thrive by changing their DNA and adapting to external changes.  Will the differentiation in the future for an organization come from investing in disruptive innovation? 

Introduction:

A nation’s vibrancy is often, visible in the halls of its learning institutions.  It was most visible recently at the 50th anniversary of University of California, San Diego whose chancellor, Marye Anne Fox, was awarded the national medal of science by President Obama just a day before.  Many of the old alumni and faculty were invited to celebrate the 50th anniversary.  Walter Kohn, a card-carrying physicist who won a Nobel Prize in Chemistry in 1998 was there.  There were talks about the origins of the university and now legendary Roger Revelle [1] “whose dream it was to establish a great institution of learning and recruit world-class scientists to come and join its faculty — for their names lured other outstanding people to come. And their prestige attracted money for research grants and superior students to enroll.  At one time UCSD’s faculty had eight Nobel laureates and 50 members of the National Academy of Sciences.  Revelle hoped to desegregate the sciences and the humanities and social sciences, because of the profound effect of technology and scientific discovery upon all aspects of modern society.”  Starting from its humble beginnings as UC La Jolla, UCSD today has grown to encompass six undergraduate colleges, five academic divisions and five graduate and professional schools. 

Equally visible were the protests from the students on recent 8-percent student-fee increase from $10,302 to $11,124 for the 2011-12 academic year, which comes a year after a 32-percent increase passed last November.  The increase is proposed because of the decline of California state budget allocated for supporting education.  “What does it say about any state that focuses more on prison uniforms than on caps and gowns?” Schwarzenegger [2], the governor of the state of California said recently, adding that “30 years ago, 10 percent of the general fund went to higher education and 3 percent went to prisons. Today, almost 11 percent goes to prisons and only 7.5 percent goes to higher education. Spending 45 percent more on prisons than universities is no way to proceed into the future.” The state’s priorities, he added, “have become out of whack.”

State and national priorities on where they invest become a critical issue in a globally competitive market place where nations fiercely compete for their market share.  In an Internet connected global economy where communication, collaboration and commerce are conducted at the speed of light, the national boundaries have blurred with respect to competition in the market place.  Technology innovations propagate rapidly and products and services get commoditized globally seeking cheap resources and customer demand.  Global corporations in their quest for profits, in a competitive environment with profit margins under constant pressure, are no longer sensitive to a nation’s local economics.  The invisible hand of economics that establishes equilibrium in a free competitive market place cannot cope with rapid fluctuations introduced by the communication, collaboration and commerce conducted at the speed of light [3].  For example, cheap labor in a particular sector of economy may transfer jobs very rapidly from one nation to another but the laid off workers cannot move with the same speed from one sector to another or one nation to another.  The time scale disparities of economic cause and response have diverged so much, with the advances in technology,  that the non-equilibrium economics becomes the norm and all the economic theories that address equilibrium and small deviations from equilibrium become the exception.  How can nations cope with this side effect of technology advances that also have improved productivity and quality of life for everyone?

The answer may lie in understanding the organizational DNA that assists in developing patterns of evolutionary advantage and competitive differentiation.

Organizational DNA, Disruptive Innovation and the Culture of Game Changers

According to a new management theory [4, 5, 6, and 7] organizations evolve developing their own DNA which contributes to their business success.  Four following base elements constitute the organizational DNA:

  1. Leadership
  2. Strategy
  3. Culture and
  4. Organizational structure

Very similar to the DNA of biological systems, the organizational DNA consists of different patterns combining the base elements and some patterns have evolutionary advantage over others that promote competitive differentiation and survival.  These successful patterns define how leadership implements  the four strategies exploiting the cultural diversity and different management structures.  The four strategies identified as primary drivers for success are:

  1. Customer intimacy,
  2. Operational Excellence,
  3. Product Leadership and
  4. Disruptive innovation.

Each strategy, the theory claims, has evolved different combinations of cultural traits and organizational style for its successful implementation.  One combination that works well for implementing one strategy may be not optimal if not fatal for implementing another strategy.  By successfully exploiting the right combinations of strategy, culture and structure, leadership manages to develop competitive differentiation in the open competitive market place to assure long-term survival and sustenance. 

In particular, the disruptive innovation as a strategy to provide competitive differentiation requires a culture of cultivation and an organizational structure that promotes collaboration between technical functional organizations that bring technical competence in multiple disciplines and business and marketing organizations that have a pulse of the market drivers.

If the theory has any validity, it has profound implications on how we approach innovation and exploit our halls of learning to be number one as a nation. 

Disruptive innovators or game changers are different breed of people who cause technological change —distinct from simple increased inputs of land, labor, and capital— which contributes to great leaps in economic growth.  As another Nobel Prize winner Solow pointed out, about four-fifths of the growth in US output per worker was attributable to technical progress [8].  On the other hand “a generation of scholars had arduously and systematically documented empirical evidence that supported the conclusion of Joseph a Schumpeter’s [9] “What we have got to accept is that the large-scale establishment or unit of control has come to be the most powerful engine of progress and in particular long-run expansion of the output.”  John Kenneth Galbraith [10] provided a postwar interpretation:  ‘There is no more pleasant fiction than that technological change is the product of matchless ingenuity of the small man forced by competition to employ his wits to better his neighbor.’”

The organizational DNA theory reconciles the observations of Solow, Schumpeter and Galbraith by pointing out that all four strategies with associated patterns are equally important for evolutionary success.  The disruptive innovation cultivated by individuals needs both technical competence and market savvy to translate into product leadership which then has to scale to sustain through operational excellence and customer intimacy.  This means that the entrepreneur and unit production cost reduction through large-scale are both essential for evolutionary success.

The cycle of product and technology maturity is described by the S-curve shown in figure 1 which describes the three phases of evolution and associated return on investment.

S-Curve depicts the evolution of technology/process innovation and associated productivity enhancements

Three important points need emphasis:

  1. Technology or process innovation that improves productivity evolves through three distinct phases (incubating, emerging and mature) which have different returns on investment.  Disruptive technologies that raise the productivity from one level to a next higher level occur through evolutionary need for competitiveness. Traditionally, as technologies start to mature, governments and corporations have devoted a part of their revenues (taxes or profits) in incubating technologies as an investment to their future competitiveness and survival.  History has shown that this investment is about 3 to 6 percent of their revenue.  History also has shown that such investment attracts the creative scientists and engineers to nurture the culture of cultivation and structures that collaborate (without the near-term profit oriented cut-throat competition) and go on to achieve Nobel  prizes  and National Science Awards.  DARPA and NSF funded projects, UCSD and AT&T Bell Labs are just a few examples.  Incubating technologies require expertise in multiple disciplines and collaboration which Roger Revelle emphasized when he was advocating the need for a university.  His main concern was that for Scripps Oceanography Institute to be successful, it needed multi-disciplinary expertise of highest quality available nearby.
  2. When the incubating technologies start to show promise as emerging technologies, the Animal Spirits and Venture Capitalists start smelling high profits and exploit entrepreneur’s product development expertise and establish product leadership.  The culture and structure required for this phase according to the organizational DNA theory is different from the culture of Nobel Laureates and structure of collaboration required from many disciplines.  
  3. As the products, processes, services  and technologies prove themselves in customer environments, conventional capitalism kicks in and large corporations exploit scale through establishing operational excellence and customer intimacy.  Again the organizational DNA theory emphasizes that the culture and structure that is exploited by conventional capitalism are different from the cultures that support disruptive innovation and establishing product leadership.  The culture of control that helps in establishing operational excellence fails miserably in creating disruptive innovation.

The long and short of the theory is that the patterns of evolutionary advantage are different in supporting different phases of implementing productivity improvements and establishing competitive differentiation.

Organizational DNA and Impact on Investment in Future of a Nation

Communication, collaboration and commerce at the speed of light have changed the global market place and both corporations and nations are struggling to establish a new economic equilibrium where they need to respond to establish competitive differentiation in a level playing field.  Global connectivity and instant information access has allowed strong coupling between minor changes in global supply and demand to cause large fluctuations in price of goods and services.  Instance arbitrage and risk management at the speed of light have introduced large fluctuations in the economic equilibrium that classical economics of the invisible hand does not address.  In addition, as the technologies get commoditized also at the speed of light crossing corporate and national boundaries, operational excellence and customer intimacy that are the hall marks of conventional capitalism [11]  can no longer provide competitive differentiation due to global competition and strain on profit margins.  This leaves disruptive innovation and product leadership in bringing new innovations speedily to market as the only options for corporations and nations to differentiate themselves.  Corporations and nations that successfully exploit these strategies with right combination of strategy, culture and structure will have an evolutionary advantage over their competitors.

During the past three decades, as conventional capitalism has thrived based on past investments in R&D, more universities, and corporate R&D efforts have been hijacked by the short-term profit motives at the expense of long-term investment that can yield disruptive innovation.  Professors have become entrepreneurs and VCs have moved to conventional capitalism by investing in coffee shops and toll roads in India [12].  This has resulted in dismantling national assets such as Bell Laboratories and engineering professors in universities focusing on their own side businesses than educating, collaborating and conducting research.  This is further exacerbated by the state and national governments diverting funds from education to prisons and pension plans for government employees.  As the recent scandals of for-profit universities demonstrate, educators are also getting drunk with short-term profit motives causing a national hangover for the tax payers [3].

If the organizational DNA theory has any merit, as a nation, it behooves us to revisit our halls of learning and reexamine our investment priorities to reestablish right strategies that are aligned with successful evolutionary patterns.  It is important to emphasize that the four strategies mentioned require different patterns of culture and structure and wrong combination may lead to a dead-end in the struggle for survival in a competitive market place controlled by the new economics of the invisible hand at the speed of light.  If there is a lesson from the organizational DNA theory for the VCs, business leaders and our legislators who are the high priests that control our investments and our future with their decisions, it is to learn that the Research and Development investments which influence conventional capitalism serve a different purpose from the investments which influence the entrepreneurs and the disruptive innovators.  They have a social responsibility to use right incentives to balance the short-term profit motives and the long-term investments towards a better future for the system as whole.  Assembling teams with right culture and structure to execute the right strategy is key to successful evolution of the system as a whole as Roger Revelle strived to do.   As we have seen recently, a few high priests can get drunk in the Wall Street [3] and cause a collective national hangover for the tax payers in a connected world at the speed of light.

After all, as Deming said “What we need to do is learn to work in the system, by which I mean that everybody, every team, every platform, every division, every component is there not for individual competitive profit or recognition, but for contribution to the system as a whole on a win-win basis.” [13].  The evolution of DNA in biology attests to this dictum. Survival depends on system thinking.  The selfish gene over time has learnt to collaborate for its survival [14].  The organizational DNA theory suggests that there is a time and place for collaboration and a time and place for cut-throat competition.  Successful DNA exploits both to its advantage.  Perhaps the organizational DNA theory is worth paying attention to.

References:

  1. http://www.sandiegohistory.org/bio/revelle/revelle.htm
  2. http://www.newsweek.com/2010/06/28/classrooms-or-prison-cells.html#
  3. An Inquiry into the Nature and Causes of the Collective Hangover of Tax Payers, When Wall Street Gets Drunk
  4. http://www.dnaglobalnetwork.com/
  5. Deming, Systems Thinking, Organizational DNA and Putting America First – Part II
  6. Deming, Systems Thinking, Organizational DNA and Putting America First – Part I
  7. Kabuki Theater, National GDP, Disruptive Innovation and Japanese Business Conundrum
  8. David B. Audretsch, Max C. Keilbach, Erik Lehmann, “Entrepreneurship and economic growth”, Oxford University Press, 2006
  9. Schumpeter J, “Capitalism, Socialism and Democracy”, Harper and Brithers, New York, 1942
  10. Galbraith, J. “Economic Development in Perspective”, Harvard University Press, 1962
  11. Can Cisco Sustain Competitive Differentiation on Operational Excellence Alone?
  12. Are the Short-Term Profit Motives and Wall Street-like Investing under the Influence, Trumping Long Term Innovation in the Silicon Valley?
  13. http://thinkexist.com/quotes/w._edwards_deming/2.html
  14. Dawkins, R. (1989). The Selfish Gene. In R. Dawkins, The Selfish Gene (p. 23). New York: Oxford University Press.
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Are the Short-Term Profit Motives and Wall Street-like Investing under the Influence, Trumping Long Term Innovation in the Silicon Valley?

6 06 2010

 

When the Wall Street gets drunk, the tax payers get a collective hangover [1].  When Silicon Valley Venture Capitalists start investing in coffee shops in India [2], will the entrepreneurs, who are this country’s best hope in creating jobs, get a severe migraine?

According to Joseph Schumpeter, the patron saint of innovation, entrepreneurs are the agents of innovation and creative destruction.  With their creative and restless quest for new approaches, they displace old products and processes with better ones often causing massive disruption to the equilibrium of economic tranquility.  The Silicon Valley Venture Capitalists institutionalized the process of creative destruction by developing the financial backbone and the economies of scale to overcome the associated risk.

According to Wikipedia “A core skill within VC is the ability to identify novel technologies that have the potential to generate high commercial returns at an early stage. By definition, VCs also take a role in managing entrepreneurial companies at an early stage, thus adding skills as well as capital (thereby differentiating VC from buy out private equity firms which typically invest in companies with proven revenue), and thereby potentially realizing much higher rates of returns. Inherent in realizing abnormally high rates of returns is the risk of losing all of one’s investment in a given startup company. As a consequence, most venture capital investments are done in a pool format where several investors combine their investments into one large fund that invests in many different startup companies. By investing in the pool format the investors are spreading out their risk to many different investments versus taking the chance of putting all of their money in one start-up firm.”

However, it seems that all is not well in the Silicon Valley.

“What’s intriguing is how that strategy has evolved, and where U.S. Venture capitalists are finding the big wins.  Forget the next iPod, or Facebook.  The firms succeeding in India are doing so with some very un-Silicon Valley-like investments.  Think toll roads.  Think coffee shops.  Think insurance companies.” 

These remarks from Chris O’brien [2] sound very alarming given the raison d’être for  venture capital firms is to invest in long-term high-risk high-gain strategies and not conventional short-term profit-making ventures.  According to Answers.com, the venture capital is money made available for investment in innovative enterprises or research, especially in high technology, in which both the risk of loss and the potential for profit may be considerable. 

Unfortunately, it seems that the current day VCs, while considering themselves as the high-priests of innovation, are not only not able to identify “novel technologies that have potential to generate high commercial returns”, but also they are plundering valuable investment capital available to them with substantial tax advantages compared to other investment firms, by looking at coffee shops and toll-roads in India for profits.

“Many VCs say their specialized financial industry merits special treatment in the private equity field because it makes long-term, high-risk investment vital to job creation.”  With this observation, Scott Duke Harris discusses current efforts by the venture capital firms to fight current government efforts to change the way the “carried interest” fee is taxed [3].

It is a good time to examine the relevance of the VC firms and their compensation in the times of large unemployment, dwindling resources and severe pay cuts elsewhere.  Where is the capital best utilized? Is it in creating innovation and paradigm shifts in the US or in coffee shops in India even with high profits?  How is a VC different from other investment firms looking for high return?

Why Does Innovation Matter?

The following extract from David A. Hounshell [4] clearly explains not only why innovation matters but also differentiates the impact of creative destruction from the conventional competitive capitalism.

“So why is innovation important? One way to answer this question is to go back to a classic paper published in 1957 by Robert Solow, an economist at MIT, entitled “Technical Change and the Aggregate Production Function” (Review of Economics and Statistics ). Solow was one of the first major economists of the postwar period to examine technological change seriously. In this paper, he studied the sources of productivity growth, looking over U.S. history, and concluded that when he accounted for all the increases in land, labor, and capital inputs and overall productivity growth, only about 40 percent of this growth could be explained with conventional economic input factors. Less than half of the productivity growth in American history could be accounted for through normal means—i.e., the means employed under competitive capitalism in Schumpeterian terms. The other 50-60 percent of productivity growth has come to be known as the “Solow residual.” Solow argued that technological change essentially constituted this residual. Technological change—distinct from simple increased inputs of land, labor, and capital—thus was a principal source of economic growth. This phenomenon in economic growth had not been formally recognized by any economist to date, although had Schumpeter been living in 1957, he surely would not have found Solow’s conclusions surprising.  Schumpeter would have said, “yes, this residual is a measure of the product of the perennial gale of creative destruction, which stems fundamentally from innovation.” Solow won the first Nobel Memorial Prize in Economics for his work, which has become a basic building block of economists’ work in economic growth theory ever since.”

The technology of creative destruction requires an entrepreneur with vision, tolerance for high risk and a thick-skin to keep persisting against all odds in an environment of competitive capitalism that attempts to suppress drastic changes to the status-quo.  The S-curve shown in figure 1 describes the three phases of innovation characterized by the return on investment.

The incubating phase where the return on investment is almost zero can only flourish with investments that have a high risk-tolerance.  Traditionally, Government institutions, universities and some large companies with vision and long-term focus have participated in developing and incubating ideas that are considered as a long-shot.  Occasionally, rich patrons who have made their money in traditional ways have indulged in incubating technologies.   On the other hand the VC’s are interested in the emerging technologies because the technologies show promise of creative destruction and associated big profits that could result from changing the game.  In order to compete with the status-quo that will attempt to stifle emerging technologies that threaten their profits, and to create the eco-systems that are required to scale and demonstrate the value of the new paradigm, the entrepreneur needs  investment, expertise and the global access that organized investment by the VC community brings.  In the past, the Silicon Valley VCs played that role very successfully with the right bets on disruptive technologies.  However, as the rising tide of their success floated all boats and created a new generation of VCs, the tide seem to have changed from emphasis on vision, disruption, and 10X improvements in productivity to incremental gains, less risk, and dubious business models such as the one that gives free software supported by labor and knowledge intensive human services that have proven not to scale time and again. 

The return on investment to improve mature technologies is poor.  Process improvements bring mostly incremental improvements in deploying mature technologies.  Investment in coffee shops brings returns not through investment in disruptive new technologies, but through process improvement to squeeze the profits or through clever marketing. Investment in coffee shops belongs in conventional competitive capitalism.  In a society struggling for resources, one precious VC dollar spent on coffee shop in India is ten dollars not realized in creating new jobs in US.  Would it not be better if investment in coffee shops is best left to Starbucks and McDonald?

Communication, collaboration and commerce at the speed of light, today, enabled by the very same technology innovation has created a new order in investment community.  Short term profit incentives, appetite for instant gratification fostered by a casino-like real-time investment in Wall Street, a twitter influenced culture of management with superficial knowledge, short-attention span of VC community and profit-at-any-cost investment culture are all contributing to the diminishing of long-term focus, innovation and civic responsibility. 

Investing in coffee-shops and toll roads in India is the last desperate leap from creative disruption to conventional capitalism in search of quick-profit.  Is this what the investors in VC firms are looking for and are the compensation and tax incentives congruent with the VC mission?  Are the same factors that created Enron, sub-prime mortgages and innovation in financial instruments now influencing the Silicon Valley VCs?

Food for thought!

References

[1] Metooeconomist, “An Inquiry into the Nature and Causes of the Collective Hangover of Tax Payers, When Wall Street Gets Drunk” (https://metooeconomist.wordpress.com )

[2] Chris O’brien , “Changing focus in India:  Deals downshift from tech to ordinary living”, San Jose Mercury News, Sunday May 23, 2010

[3]  Scott Duke Harris, “Uncle Sam eyes bigger slice of VC”, San Jose Mercury News, Friday, June 4, 2010

[4]  David A. Hounshell, “Innovation and the Growth of the American Economy”, The Newsletter of FPRI’s Wachman Center, Vol. 14, No. 3, February 2009 (http://www.fpri.org/footnotes/1403.200902.hounshell.innovationamericaneconomy.html )