CHAPTER 2
Governing Innovation in Practice: The Role of the Board of Directors
I said: I am going to challenge my board! Because what is a board for?
For me, I think the board basically has two tasks:
The first one is to assure that they have a good CEO and that he performs.
And the second one is to assure that the direction is the right one for the interest of the group.
Peter Brabeck-Letmathe, Chairman of Nestlé SA1
A first look at the board's role in governing innovation raises a paradox. On the one hand, the board must manage risk, ensure stakeholder benefits, and, in general, keep the company on an even keel into the future. On the other hand, in fulfilling that mission the board is likely to dampen the company's appetite for innovations that go beyond incremental improvements of offerings already on the market. In this chapter we will argue that the board's involvement in innovation is critically important if the company is to articulate and pursue an innovation strategy that reflects the considered judgment of the board and top management.
Although there may be room for the board to become involved in issues that touch on innovation governance, this is not spelled out in any of the board roles that we have reviewed. For example, the responsibilities of the board at Herman Miller, a Michigan-based furniture company, are:
Although there is no mention of innovation in Herman Miller's board responsibilities, the company has included a board member with impressive innovation experience. And indeed, despite the apparent absence of innovation responsibilities in the description of the role of most boards, we firmly believe that the board is critical in shaping management's approach to innovation.
Clarifying the Scope of the Board's Role in Innovation
The role of the board is critical whether or not it takes an explicit role in defining an innovation strategy and approach, since – as we suggest above – management will respond to the board's tacit attitudes to innovation, even if they are not spelled out or addressed explicitly. Promoting innovation and ensuring that management addresses it appropriately should therefore be a key duty of the board. Otherwise, management is left to guess about innovation parameters, and the results too often cause major waste and missed opportunities. Whether the company's innovation portfolio includes the pursuit of radical innovation, what the innovation payback time frame is, what the company will invest in innovation – these are all questions that should be explicitly discussed between the board and top management. It is essential to weave innovation issues into the board's overall governance mission, while recognizing the differences between top management's executive role and the board's governance duties.
Among the many governance duties of the board, five areas should draw our attention because of their potential impact on innovation:
- strategy review;
- risk management;
- auditing;
- performance review; and
- CEO and top management nomination.
In order to address the governance duties of the board as they affect innovation, we will regroup these missions into two major areas. The first is innovation strategy, including regular audits of both leading and lagging indicators of the company's innovation performance, as well as the board's role in defining acceptable ranges of risk. The second is the board's role in performance review and replacement of top company officers. We will conclude this chapter with reflections on selecting and developing a board that has a deep interest in innovation, with the experience and expertise to act as a competent partner for management.
Reviewing the Company's Innovation Strategy
Participating in Strategy Discussions
Boards generally take their role as company strategy reviewers seriously. At the very least, the CEO informs them of the major strategic issues facing the company and of the options management proposes to address them. These strategic issues often come up and are discussed when board approval is required for major investment decisions. In some cases boards may be invited to attend off-site strategy retreats and participate actively in formulating strategy together with management.
Despite their general involvement in strategy – and apart from discussions on specific and vital new products or new technologies – boards often lack the opportunity to discuss innovation strategy in detail, at least in a regular or structured way. One reason for this may be that management has not always explicitly formulated innovation strategies. This is partly because “innovation” covers a wide range of corporate activities. There is no simple formula a company can follow that describes its relationship to innovation.
For some companies, innovation means having a full portfolio of innovations, from radical new markets and technologies to incremental improvements of existing products and services, to cost reductions. To be successful, these companies have to accept some long payback times and a relatively high degree of risk. Other companies insist that innovation must pay off in a short time frame. To succeed, they have to limit their innovations to areas in which the uncertainty is low, their familiarity with technology, market, production, and financial issues is high, and the time frame from initiation to launch is short.
Confusion over a company's innovation strategy may be one of the major causes of innovation waste and failure. When the board is not engaged in governing innovation, when the company's innovation strategy is not made explicit, then top management has no choice but to guess what the board wants. Although most companies want to be known as “innovative,” a number of factors push boards toward a conservative position. The one that has the most impact is the stock market. Publicly traded companies are judged on the basis of investors' confidence and willingness to invest. Stock prices are evaluated quarterly or biannually. An innovation that will not pay off for several years is generally seen as a loss in that equation, and investors hate to see their investments take a hit. Companies such as Nestlé or Corning, which boast a willingness to invest “patient money,” are rare.
If the board is likely to view innovation conservatively, then top management, whose performance and compensation are dictated by the board, will probably follow suit. It is all too frequent to see top management touting innovation and even funding exploratory projects that might unearth new and innovative opportunities, yet giving the clear signal that serious investment – the resources needed to get a product to market – will be limited to projects that have low risk and short-term payback.
Communicating the Company's Innovation Thrusts to the Board
In order to ensure that the company has a clear and explicit innovation strategy, which is agreed by board and management, the board should ensure that top management communicates its views and intent in four areas pertaining to innovation:
- How it rates the strategic importance of innovation for the business and where it expects major innovations to emerge.
- How that might change in the future in terms of intensity and focus, and what this means for the company.
- How it plans to meet future market demands for more innovative offerings and for more competitive new products and services.
- And, more generally, how it plans to invest in innovation, not just in R&D, to boost its innovation performance.
To help clarify what the innovation strategy will amount to in practice, the board should go further. It should expect management to communicate its innovation priorities and provide an estimate of the resources the company is planning to invest by type of innovation. The distinct innovation thrusts, which have generally been described as an innovation portfolio, should include at least the types of innovation described below:3
- Internal development of incrementally new and improved next generation products, processes, or services.
- Internal development of radically new categories of products, processes, or services (i.e. new to the world, not just new to the company).
- Development together with partners and/or complementors of a radically new business model or system.
- Development together with partners and/or complementors of incrementally new customer solutions.
The innovation portfolio is in fact an investment portfolio, and the board needs to know where, how much, and how management intends to invest in these four broad strategic innovation categories and to review how the company is progressing in each of these areas. With innovation investment made explicit in this manner, top management will be better able to resist the conservative drift to incremental innovation, and the board will be better able to judge the performance of the top team in relation to the board's innovation strategy. Developing this investment plan requires the board to work with management to define the risk parameters.
Being Aware of and Managing Innovation Risk
Boards have a fiduciary responsibility to shareholders to be the ultimate guardians of the company's risks. In most cases, the risks they scrutinize are financial in nature and their audit mission aims to recognize and address them. In some industries and companies, other risks are regularly reviewed and assessed by the board, e.g. environmental risk and political risk. In other industries, such as the pharmaceutical industry, product liability and class-action risks are important subjects of board review. All of these kinds of risk can be relevant to innovation: innovation affects stock prices; innovation is a critical aspect of avoiding environmental risk and achieving environmental gain; and innovation plays an important role in preventing risks due to product liability.
The key issue for the board to consider with respect to innovation, however, is how much risk the company is willing to take on. Here again we see the push toward innovation conservatism. If the board has not been explicit about its risk tolerance, management is most likely to limit risk in order to limit its exposure to board criticism and censure. In such companies, the board should therefore see its mission as stimulating management to take sensible risks to innovate. In the absence of clear mandates from the board, companies that can be truly innovative need strong governance from within the top management team. The paradigm for this today is Steve Jobs, and there are plenty of examples throughout the history of innovation, including Edwin Land at Polaroid, A.G. Lafley at P&G, and Sam Palmisano at IBM. At 3M it was William L. McKnight, who became president in 1929 and served as chairman of the board from 1949 to 1966. He encouraged the company's management to “delegate responsibility and encourage men and women to exercise their initiative,” thus creating 3M's iconic “culture of innovation.” But CEOs come and go and the board needs to create and communicate a clear understanding of the limits of innovation risk.
So the board needs to be aware of and oversee the risk that accompanies innovation (both internal risk and external risk), and it needs to agree on and clearly communicate the acceptable innovation risk profile for the company.
Internal Risk
Part of the innovation risk may be purely internal, for example when the company commits significant resources to a new and untested technology, a risky and uncertain product concept, or an unfamiliar new market. Often this kind of internal risk can be handled by the management team. Managing the innovation portfolio, if made explicit, will allow for such risk. If it is clear that a percentage of the innovation portfolio will be invested in radical new ventures, then when, for example, a radical new technology under development is found to be unworkable this will be seen as an acceptable outcome.
Another kind of internal risk deserves board oversight. This is when the activities of individuals and teams seriously – and in some cases irrevocably – alter the practices or the character of the company. It is usually up to top management to recognize the importance of involving the board in such instances, and it is up to the board to be willing to deal with such issues. Recent experiences in the banking industry indicate that neither senior bank managers nor board members were fully aware of the risks introduced by the new and complex derivative products conceived by some of the most innovative traders. In some banks, the board clearly did not exercise its governance mission in relation to innovation and new products. In this case, of course, it was not only a failure of innovation governance – the bank executives and board also failed in their responsibilities to “oversee the processes for maintaining the integrity of the company.”4
The bank example is a matter of integrity, but frequently internal risk occurs when external forces such as disruptive technologies or market opportunities, or a combination of them, threaten to change the very nature of the company. Many years ago, Polaroid hired a consultant to help it begin to navigate the perils of the “digital age.” But the company never seriously explored what it might be able to develop and market given its vast technology resources and understanding. Perhaps worse, it was not willing to devote significant resources to digital projects that would not provide revenues through the sales of film cartridges. When a company needs to radically reinvent itself, it is important that the board be a partner in helping to navigate this tricky terrain.
How does a company move from one business model to another? John Seely Brown, who now sits on the board of directors at Corning, was previously the chief scientist at Xerox and director of its Palo Alto Research Center (PARC) in the 1990s. He had this to say about understanding the importance of the business model:
Not everything we start [at Xerox] ends up fitting our businesses later on. Many of the ideas we work on here involve a paradigm shift in order to deliver value. So sometimes we must work particularly hard to find the “architecture of the revenues” … Here at Xerox, there has been a growing appreciation for the struggle to create a value proposition for our research output, and for the fact that this struggle is as valuable as inventing the technology itself.5
Open innovation has been accepted in recent years as a “new paradigm” for innovation. Henry Chesbrough6 opens his book, Open Innovation, with a chapter on Xerox PARC, which is famous for having developed many of the technologies that have radically changed our world, but for having benefited from relatively few of them. Chesbrough notes that many people blame “Xerox,” “corporate management,” or simply “the corporation” for the failure to harvest value from PARC's work. He, however, has a different perspective. Perhaps a better explanation, he tells us, would be that Xerox was executing a system of innovation within which the success of the innovations that PARC spun off “was largely unforeseen – and unforeseeable.” At the time, Xerox's innovation system was closed, not open, and therefore there was little or no understanding of how to develop and manage the fruits of the company's research.
One of the key issues in Chesbrough's book is the business model, which is “how companies of all sizes can convert technological potential into economic value.” When companies are struggling with such radical decisions, it is essential to have leadership that can help negotiate the terrain, and this includes a board with a clear and ongoing commitment to the issues of innovation. What was the role, one wonders, of the board as IBM opened its coffers, gave away what it had considered to be its treasure, and moved to a whole new business model based on service?
External Risk
The other part of the innovation risk is external and deals with competitors' development and spread of disruptive technologies that can make the company's offerings irrelevant. Recent examples of company demises abound, particularly in the digital economy. The threat may come from a new technology chasing the old one, as with digital photography. But it can also come from a radically different perspective on the market, as happened when Apple launched its iPhone to appeal to consumers, in contrast with the professional smartphone approach followed by Research in Motion (Blackberry's promoter) and Nokia. Both companies were obviously caught unprepared by Apple's emphasis on consumer markets. Managing this type of risk requires management's constant attention on weak signals of emerging trends, a willingness to consider shifts in business models, and sufficient humility to keep challenging the company's beliefs. The board does not have to see the emerging trends on its own, but its governance function requires it to be aware of the risk of disruptive innovation, to ask management to keep a lookout and report back to the board, and to be willing to fund research to uncover such signals and trends. It must continuously ask what if? questions while listening to management's often reassuring strategy remarks.
Auditing the Company's Innovation Effectiveness
To take on the responsibility of a governance role in relation to the company's innovation strategy, the board will have to review the company's innovation performance, for example by including innovation in the range of activities that are audited. All boards of course focus on financial audits, and they gradually have been extending the range of their supervisory auditing missions. For example, in environmentally conscious companies, the board, together with management, often becomes involved in setting environmental performance targets and in reviewing corporate scorecards against these targets at regular intervals. Similarly, aware of the impact of the human factor in overall corporate performance, boards are increasingly encouraging management to conduct employee engagement surveys and to review them regularly.
In companies for which innovation is crucial, innovation should be on the list of board auditing missions. It is indeed within the legitimate role of the board to ask top management to set a small number of critical innovation effectiveness measures which it can regularly review and discuss with management.
Innovation measures that are relevant at the board and top management levels typically include input and output indicators which can be compared with accepted industry benchmarks. In technology-intensive companies, the level of R&D expenditures – in absolute terms and as a percentage of sales – is a classic example of such innovation input indicators. A frequently measured innovation output indicator is the percentage of sales achieved through products introduced in the past several years (the amount of time depends on the natural product renewal rate of the industry). Many companies, Medtronic, Hewlett-Packard, and Logitech among them, measure and communicate about this ratio regularly, so their boards are probably tracking this indicator.
More advanced innovation trackers go beyond these accepted innovation metrics, i.e. beyond input/output indicators, to keep an eye on measures that reflect not only what the company is doing but how. This approach allows the company to monitor the leading indicators of effective innovation. For example, if the board and management have articulated a clear strategy with respect to portfolio balance, then the board should ask management to report on this aspect regularly. Furthermore, even when the approved projects reflect the desired balance, companies frequently fail to adequately resource the portfolio. The degree to which this is done could be a key leading indicator of innovation effectiveness – it is startling to discover how often management “approves” a project but fails to resource it. The board can therefore provide an important reality check by asking management to report on the metric of portfolio resourcing.
The board can also ask management to set metrics for strategic goals and keep the board informed on how well they are being met. For example, more and more companies are rising to the challenge of open innovation. To make sure that the company is making strides in achieving such a goal, top management can easily measure the number of projects that include development partners to introduce radically new business models or incrementally new customer solutions. The board and management can set targets and together they can assess the company's progress over time.
Another type of strategic goal might be achieving critical process targets for innovation. For example, the board might want to know whether the company is good at understanding customers and their needs, or whether the company has a good grip on technology resources – its own as well as those of potential or actual partners or competitors. The board could ask questions such as whether the company is using ethnographic practices, or whether it excels at mapping technology, but we have found that a better option is to ask whether they are meeting the key objectives. Although responses to such metrics are likely to be subjective, a broad range of responses will indicate whether or not the company is proceeding as expected or whether there is a gap that should be filled.
The challenge for the board and for management – and this applies to most performance indicators – is to select only a small number of relevant indicators worth board review, and to make sure these indicators are regularly changed in line with the company's progress. This should result from regular in-depth discussions within the board, together with management, as to the company's main innovation challenges, opportunities, and deficiencies.
Reviewing and Nominating the CEO and Top Management
Auditing Management's Innovation Performance
A vital role of the board is to evaluate the performance of the CEO and the top management team as a basis for decisions on compensation packages and CEO succession. To do this, some companies have developed sophisticated formulas similar to the traditional balanced scorecard concepts used by many human resource departments. CEO scorecards usually combine financial figures and targets – generally based on company growth, profitability, and stock price, among other things – with other qualitative or quantitative measures or specific goals pertaining to the company's strategic initiatives and priorities, such as specific turnaround targets, progress in globalization efforts, capital efficiency improvements, and the like.
Companies that depend on the introduction of “make or break” new products – think of Boeing with its 787 Dreamliner – generally include the review of these large projects in the board's deliberations. In these companies, the board is most likely to make the compensation packages of the CEO and top management team contingent on the successful completion of important milestones. But for many companies innovation results are not explicitly part of the CEO's balanced scorecard. It is somehow included in other, more general performance indicators like growth or market share gains which, as we have seen, often tend to dampen innovation efforts.
This is why it is desirable, at least in innovation-oriented companies, also to evaluate the top management team and CEO on the few innovation performance indicators that they will have suggested to the board as the result of their audit.
Appointing an Innovation-oriented CEO
The selection and recruitment of a new CEO after the current CEO's retirement – or his/her removal – is undoubtedly one of the board's most visible and difficult responsibilities. With the gradual reduction in the length of CEO contracts, this is capturing a lot of attention from the business media.
The appointment of a new CEO always has implications for innovation. Sometimes the new CEO will have a similar approach to innovation as his/her predecessor; sometimes it will be very different. If the board has been playing a role in innovation governance by engaging in some of the activities we have already suggested, it will be more likely to take into account the company's innovation strategy and goals, as well as strengths and weaknesses, when it makes the selection.
Boards frequently appoint what management author Robert Tomasko calls a fixer to the CEO position, since they generally feel more comfortable with the more predictable fixers than with the innovative but sometimes more erratic growers.7 This happened at Polaroid with the transition from Edwin Land, the historic innovator, to Mac Booth – a clear shift from a grower to a fixer. GE under the leadership of Jack Welch produced a number of fixers who have joined the ranks of top management in US companies in recent years.
When 3M was looking for a new CEO in 1999/2000 the board turned to a talented fixer from GE, James McNerney, a nomination that several analysts considered a casting error for an archetypal innovative company like 3M. In conversations with several 3Mers in 2005, we gained a strong impression that McNerney was bringing welcome discipline to a company that had been, and still was, an icon of innovation. One interviewee felt that his productivity as an inventor had doubled since he began using the Six Sigma processes that McNerney had introduced. He began averaging two patents per month. “The trick,” he said, “is to have the appropriately flexible structure.” Geoff Nicholson, the legendary promoter of the Post-it Note, had been pleased to learn that McNerney identified two parts of the development process – the creative front end and the disciplined back end. “The disciplined back end brings focus, but if you bring that focus too soon, you can kill off the idea.” Again, the key is balance.
More recently, however, the reports we received from 3Mers were more negative. The feeling was that the structure was taking over the culture of innovation, and people were relieved when McNerney was replaced. He then joined Boeing which badly needed a fixer.
Of course, growers are often needed to challenge the status quo and get the company embarked on a new growth phase. This is another key reason why it is so important to remind boards of their innovation governance responsibility. It does not mean that they should always choose growers over fixers. But it does mean that they should put their nomination in context by considering the top management team, not just the CEO. If a fixer is needed at the top, who will take the grower's role within the executive committee? And will the new CEO support his/her colleagues as they defend an innovation agenda? In later chapters we will discuss different ways of allocating the governance responsibilities for innovation within the company. The more the board is aware of how these responsibilities are framed and carried out, the higher the chances that it will be in a good position to select the right people for the right jobs as far as innovation is concerned.
Selecting and Developing the Board for an Innovation Focus
One approach to building an innovation focus in the board is to be sure to include board members with the relevant experience, expertise, and passion. As mentioned earlier, Corning's board includes John Seely Brown, who was director of Xerox PARC, and Herman Miller's board includes John R. Hoke, former creative director and now vice president of Global Footwear Design at NIKE.
Similarly, Nestlé's board includes Daniel Borel, the innovative founder and former CEO and chairman of Logitech. Boards also often include present or past presidents or CEOs. For example, Sam Palmisano remained on IBM's board even after he retired as president and CEO of the company. And so did Peter Brabeck-Letmathe, the visionary former CEO of Nestlé. Boards with members like these are better able to articulate the board's role in innovation governance and to oversee the innovation governance models deployed in the company. It is still such a new topic that even the most seasoned innovators may not be aware of the opportunities it affords.
It is also important to develop the existing board members' understanding of their role in relation to innovation. One approach is to offer workshops on innovation to board directors, as the Malaysian Directors Academy (MINDA) has begun to do for the directors of state-owned enterprises, for example. Some executive education resources include training in innovation for directors, and some companies have begun to hold directors' retreats that focus on issues in innovation.
Perhaps the most sophisticated and intensive approach we have seen is the one adopted by Corning Inc. The day before each board meeting, a 2½ hour “technology with the board” session is held in which directors are informed about upcoming technology projects and updated on projects that have already been approved. One board meeting per year is devoted exclusively to technology issues. In addition to these regular sessions, board members travel to Corning's overseas plants, and every two years they “don smocks, protective glasses, and comfortable shoes and take a tour of the company's sprawling Sullivan Park research facility in Corning, where most of the new ideas are hatched.”8
Corning is a company that has reinvented itself through technology innovation throughout its history. The boards of most companies will not need the same degree of immersion in technology as Corning's board; however, Corning provides a good example of how a board can be kept up to date with the company's innovation agenda.9
In conclusion, it is imperative that the board make its position on innovation clear in order to provide the necessary alignment of activities and resources so that employees can direct their efforts toward fulfilling the company's innovation goals. The board's role in innovation governance must include:
- aligning with an articulated innovation strategy;
- defining risk parameters;
- requesting regular audits which show alignment with strategy and risk; and
- discussing the innovation capabilities/performance desired in top management.
In addition to these, the board would be wise to add to its members individuals who have experience and expertise in innovation and to set up opportunities – be they retreats, education sessions, part of regular board get-togethers – for the board as a whole to become involved in and knowledgeable about the company's innovation capabilities.
In this way the board can begin to play an active and useful role in innovation governance. As board members become more aware of the governance models in use at their company and others, they will also be more able to use their position to push top managers to reflect on and improve the models currently in use.
Notes
1 Extract from a videotaped class session with executives at IMD on the case “Nestlé SA: The Wellness Company” by Peter Killing and Bettina Büchel (IMD-3-1666, 2006).
2 Verbatim from the Herman Miller website.
3 Refer to Chapter 6 of Innovation Leaders: How Senior Executives Stimulate, Steer and Sustain Innovation by Jean-Philippe Deschamps, Wiley/Jossey-Bass (2008); refer also to New Product Development for Dummies by Robin Karol and Beebe Nelson, Wiley (2007), p. 213.
4 Taken from Herman Miller's list of board responsibilities.
5 Chesbrough, H. (2003). Open Innovation: The New Imperative for Creating and Profiting from Technology. Boston, HBS Press, p. 63.
6 Ibid.
7 Tomasko, R.M. (2006). Bigger Isn't Always Better: The New Mindset for Real Business Growth. New York: Amacom.
8 Engen, J.R. (March/April 2007). How Corning's Board Stays on Top of Technology. BoardMember.com.
9 For Corning, one outcome of the telecommunications downturn in the late 1990s was the setting up of top management governance boards and the commitment to a more diversified portfolio. The board, along with top management, was prepared to take on the nearly fatal situation and rebuild the company. We'll hear more about Corning's innovation governance model in Chapter 8.