From Strategic and cultural contexts of real options reasoning in innovation portfolios by Carsten Kaufmann, Alexander Kock, and Hans Gemünden, in Journal of Product Innovation Management (2021).
Any return requires risk. One of the biggest challenges that businesses face in becoming more innovative is the large risk associated with investing money in innovation.
Innovation projects naturally surround themselves in an environment of uncertainty. This uncertainty is what allows innovation to change industries, but is what also makes it increasingly risky as an investment.
For many businesses, most especially those in emerging economies, a challenge arises as large risks are obligations that they cannot afford to take.
There are many reasons to try being innovative, however – as innovation allows one to stay ahead of the industry and enter new markets earlier than the competition. These are significant financial benefits that a company foregoes when it decides to stay in the status quo. This can lead to the long-term harm of being left behind as other firms move forward.
Risk thus exists symmetrically, as there are risks associated with both being innovative and with failing to be innovative as well. What matters therefore is accepting that the risk exists, and creating strategies to mitigate it. There are two basic strategies to do this: (1) building innovation portfolios, and (2) investing using real options.
Investment Portfolios and Real Options
An innovation portfolio is a set of innovative projects being undertaken by an organization. This helps to diversify the risk by having several different projects with different chances of success or failure. This way even if one project fails, there is another project that can succeed in its place.
A real option is an investment made as a right rather than as an obligation. What this means is that unlike standard investments, where one allocates a fixed amount of money and owes that to a project; a real option is an investment that changes its value over time.
This investment is thus characterized by three key features:
- Small investments made over time – rather than making a one-time big-time investment, real options make several small investments periodically. This lowers risk by spreading out the decision to invest.
- Decisions can change – as projects show signs of failure or success, the value invested can be increased, decreased, or terminated. This means investments can be reallocated from worse performers to stronger ones.
- Innovations projects compete – for a project to get more investment, it must be more successful than other projects to become a priority. This incentivizes them to perform better.
These three features act to lower an investor’s commitment, allowing them to more easily back out of potential failure and more easily jump into projects more likely to be successful. This reduces the uncertainty of investing, as one can change his value as more information presents itself over time.
Making an Innovation Portfolio Successful
Developing a system to lower risk and increase investment in innovation is nothing, however, without the new ideas and people needed to execute them. Thus, to build a successful innovation portfolio, companies must develop two things:
- An entrepreneurial orientation. Key decision-makers must be willing to take some risk to be innovative and be proactive in searching for and identifying innovative opportunities. If the strategic orientation of the company does not allow any strategic risk or never opts to try new things, then an innovation portfolio will fail to take the opportunities that matter the most.
- An innovation climate. Innovators need to be in an environment where they are supported – where employees can raise ideas, gain support from their leaders, and experiment in their implementation. If the cultural context of the company is against innovation, then the innovators conceptualizing or executing these ideas will encounter significant resistance in their projects.
For companies to start succeeding in becoming more innovative, they thus need to start with three initial steps.
- Accept the risk, and find ways to mitigate it. Diversify investments across different projects, and adjust investments over time as uncertainty decreases. The future losses of not being innovative are much greater than any present loss one experiences today.
- Build a culture where innovation can thrive. Let employees know that you are open to hearing their ideas and willing to invest in those that work. One can never know who or from where the next big innovation will come from, so it’s important to keep an open ear and give everyone the chance to propose new ideas, experiment, and execute innovations.
- Choose to be innovative from the top going down. Search for innovative opportunities and set an example for the whole company to follow. Evaluate ideas fairly and pursue opportunities as they present themselves. Take calculated risks and explore big ideas to demonstrate that the company is an innovator, and its employees can be too.
These build the foundation and first steps to jumpstart innovation in one’s own company. It doesn’t necessarily have to start with a big investment, but rather, with taking a chance and being open to change.
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