Managing your Innovation Risk Tolerance

I am proud to have authored one of the top 10 most popular posts in the history of Executive Street: The 3 Stages of Innovation. In that post, I pointed out that various innovation strategies are directly correlated with industry stage. When it comes to innovation, timing is everything.

The other critical variable in continuous innovation is an entrepreneur’s tolerance for risk, which is often driven by a multitude of factors such as the profitability of the business, level of private equity investment, etc.  What wagers to make and in what amounts could be the single most important decision a business owner makes.

In the 3 Stages article, I referenced three distinct innovation types: market disruption (white space), up-market disruption (service innovation) and low-end disruption (commoditization).  Another spin on this theory was recently articulated in the Harvard Business Review (Managing Your Innovation Portolio-Nagji and Tuff May, 2012) who outlined the optimum innovation allocation strategy for established firms.

Naji and Tuff suggested that the most profitable of companies (according to two recent studies) allocate roughly 70% of resources to core businesses, 20% to adjacent businesses and 10% to disruptive innovation.  This allocation is based on risk and reward: companies can realize the highest likelihood of ROI in the business they already know, can invest in short term growth in businesses directly adjacent, and invest for the future in white spaces.

The science employed in these studies would validate previous writings of Keith McFarland in the Breakthrough Company who maintained that many entrepreneurs are overly eager to expand into adjacencies (and disruptive innovation) when they sense they are running out of runway in their core business. There are many variables to consider, but as a general rule, it is easier to grow share from 20% to 40% in an existing business than to try to grow from zero to 20% share in a new market. Naturally, the amount of competition, channels of distribution and other factors can dramatically affect the impact of any innovation strategy.

The motivation of the entrepreneur can not be understated when considering risk tolerance. Some business leaders (such as those in technology or those that employ high levels of financial leverage), may be driven towards a higher appetite for risk (and resulting returns).  In such cases, investment in core businesses could be significantly less (perhaps 40%-50%) while investment in new offerings and disruptive strategies are ratcheted up.

The chosen risk tolerance will dictate which innovation investments will be made. For example, to grow into white space may require hiring staff with specialized skills.  To expand a core competency may require better systems, processes or command over raw materials, such as is often achieved in a vertical integration strategy.

It is important for management teams to consider these factors early on in the formation of strategy.

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