Bringing Innovation Back

This report recaps a CEO roundtable discussion on the mindset of risk at the 2017 Chief Executive of The Year event in New York, co-sponsored by Chief Executive and PURE Insurance. This is part 2 of 2, click here to read part 1.

As with insurance and telecommunications, the closely related defense and aerospace industries are grappling to find ways to spur greater innovation.

Roger Krone, chairman and CEO of Leidos, which manages military health records, is a veteran of 30 years at McDonnell Douglas and Boeing. He said the great burst of innovation in these industries occurred at the hands of Sandy McDonnell, Jack Northrup and Bill Boeing, who built the companies bearing their names. Then the field consolidated.

“There were probably 50 standalone companies and now there are probably less than a dozen,” Krone said. “Now we have these big companies. We all got MBAs and read [management] books and the innovation just stopped.” T

he fact that the U.S. government for many years paid for the costs of products developed for the military plus a guaranteed profit, the so-called “cost-plus” model, also contributed to a general decline in risk-taking and innovation, he noted.

“One question mark hanging over the innovation efforts of all large companies is the impact of activist shareholders.”

As a result, there is deep concern at the U.S. Department of Defense today that the U.S. military is losing its technological advantage over potential enemies, Krone noted. Major defense contractors such as Lockheed have created internal skunkworks and rotate people in and out of these innovation “enclaves.” The Pentagon also has created a Defense Innovation Unit Experimental to reach out to the talent in Silicon Valley.

But the sense remains that the traditional defense companies are lagging behind Elon Musk and his SpaceX, Solar America and Tesla companies. “We looked at Elon and we all bet that he would fail,” said Krone, who, among other jobs, managed the International Space Station. “But right now, Tesla has the highest market capitalization of any car company in the U.S. and there is a message in that. Maybe Elon’s biggest legacy will be that he convinced the government it was okay to take risks again.”

Some CEO participants pointed out that a publicly traded company subject to quarterly earnings reports—and under pressure from activist shareholders—has a tougher time making a long-term, big bet than its privately held peers. “Originally, Elon could take risks because he wasn’t a public company,” Krone argued. “He didn’t have to close his books the way we have to close our books. He didn’t have Sarbanes-Oxley Section 404. He was able to create SpaceX and Solar America and Tesla in an environment where he could control a lot of the variables.”

Incubation vs. Acquisition

Large companies often have difficulty in recognizing an innovation when it happens in a detached skunkworks environment. Moderator Jeffrey Sonnenfeld, senior associate dean at Yale University, pointed out that Xerox’s research center in Palo Alto, California, came up with the concept of using a mouse to control a computer, but Xerox could not imagine a use for it. Apple recognized the potential and made billions from the concept. “The question is, how do you bring an innovation back into the core of the company?” Sonnenfeld said.

Often, executives at headquarters are skeptical of the people who work offsite in innovation centers, posited Thomas Siering, CEO of Two Harbors Investment, which has spun out several different real estate units. “The problem I’ve faced is with what we call the civilians—the lawyers and accountants,” Siering said. “They think of the innovators as rogue operatives. Culturally, it can be a real challenge.”

Instead, some larger firms opt for an acquisition route to innovation, allowing small companies to develop a technology and either make mistakes or get the formula just right and then snap them up. “Don’t do it in-house” with a new technology, advised Stephen Jones, CEO of Covanta Holding, which turns waste into energy. “Let it go out-house somewhere and then acquire it.”

If major acquisitions and internal innovation strategies are difficult, it may be that the strategy of partnering and perhaps acquiring smaller companies is the best way for a major company to remain at technology’s cutting edge, said Stephen Marcus, the CEO of Cantex Pharmaceuticals, which is in clinical trials with several new medicines. “For Pfizer, it’s okay to take 10, 12 or 15 years to develop a great product. But in a small company, venture capitalists basically want an exit within five years. So it doesn’t necessarily mean that you develop a drug all the way. Sometimes it’s developed to the point where it looks highly likely that it will be commercialized. Then a Pfizer or other major company comes along. The engine of innovation now is largely small companies.”

Tom Rogers, who built and sold TiVo and is currently executive chairman of Winview, said it was much the same in the media and Internet worlds, where long-term strategic investors want a new idea to be “de-risked” at a smaller company before they commit to buying it. Major companies want to see if a start-up can survive two or three rounds of financing and demonstrate staying power before they step in and commit major resources to expanding the startup’s technology. “Basically the whole venture capital ecosystem serves in many ways to de-risk the entire decision-making process,” he said.

One question mark hanging over the innovation efforts of all large companies is the impact of activist shareholders, who take a stake in a company and then look to force their way onto the board and influence management decisions. Nelson Peltz of Trian Fund Management, for example, played a role in persuading the board of General Electric to retire Chief Executive Jeffrey Immelt.

Bob Nardelli, who famously competed for the top job at GE before moving on to Home Depot and Chrysler, predicted that the activist attacks will eventually fade. “The activists will go away when the market stalls and they can’t go in and get a quick hit,” said Nardelli. “When the market tips, I think the activist act will be over.” Every CEO of a publicly traded company can only hope he is right.