Governing Innovation in Practice – The Role of the Board of Directors

By: Jean-Philippe Deschamps

Is innovation part of the governance mission of boards of directors? At first sight, the answer seems to be “no”. In this new series of two articles professor Jean-Phillipe Deschamps delves deeper into the specific role of the board of directors and that of top management in exercising their innovation governance responsibilities.

In a previous series of three articles published by InnovationManagement, I introduced the concept of innovation governance. These first articles covered: (1) the definition and scope of innovation governance; (2) the organizational models that companies have chosen to allocate innovation management responsibilities; and (3) a first assessment of the perceived effectiveness of these models. In this new series of two articles, I propose to review the specific role of the board of directors and that of top management in exercising their innovation governance responsibilities.

Is innovation part of the governance mission of boards of directors? At first sight, and based on the board agendas that I have had a chance to observe, the answer seems to be “no”. Innovation belongs to the realm of management, and boards leave that mission up to them. They expect their top management teams to fully exercise their responsibilities regarding innovation, i.e. how to stimulate, steer and promote it corporate-wide.

I will argue that the role of the board is critical in shaping management’s approach to innovation.

Board members have two additional reasons to shy away from most innovation issues — barring those with a considerable investment or risk profile. First and foremost, board meetings are limited in number and duration, and agendas tend to be crowded with statutory corporate governance issues. Second, innovation questions tend to be complex, combining hard and soft process considerations that cannot easily be addressed as a series of clear-cut decisions.

However, it would be wrong to believe that boards are not aware of their growing role and involvement in the field of innovation. I witnessed this personally when I was approached by the Malaysian Directors Academy, or MINDA, to deliver a workshop for government-linked company directors to increase their understanding of innovation issues and their role in addressing them. As we shall see below, boards have ample opportunities to influence management in this critical area.

In this article I will argue that the role of the board is critical in shaping management’s approach to innovation.  Going further, I will posit that promoting innovation and ensuring that it is adequately addressed by management should become a key duty of the board, while of course recognizing differences between top management’s executive role and the board’s governance duties. As I will discuss below, it is a matter of weaving innovation issues into the board’s overall governance mission.

Among the many governance duties of the board, five areas should draw our attention because of their potential impact on innovation:

• Auditing;
• Strategy review;
• Performance review;
• Risk management;
• CEO and top management nomination.

Auditing the company’s innovation effectiveness

Besides their traditional focus on financial audits, boards are gradually extending the range of their supervisory auditing missions. For example, in environmentally-conscious companies, boards, together with management, often get involved in setting environmental performance targets and in reviewing the corporate scorecards against these targets at regular intervals. Similarly, conscious 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 critical — and there are many of those in a wide range of industries — innovation should be added to the list of the board’s 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 should be added to the list of the board’s auditing missions.

These measures will typically include input and output indicators to 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, but there are many others to be considered. Similarly, 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). Companies such as Medtronic, Hewlett Packard and Logitech measure and communicate about this ratio regularly, so their board is probably tracking this indicator. And there are other indicators worth reviewing as part of a regular innovation audit.

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 reviewing by the board, and to make sure these indicators are regularly changed in line with the company’s progress. This should result from in-depth discussions within the board, together with management, as to the company’s main innovation challenges, opportunities, and deficiencies.

Reviewing the company’s innovation strategy

Boards generally rate highly their role as company strategy reviewers. At the very least, they are informed by the CEO of the major strategic issues faced by the company and of the choices proposed by management to address them. These strategic issues often come up and are discussed with major investment decisions for which board approval is required. In some cases – I witnessed it personally in the board of a global multi-billion euros company on which I sat – boards may be invited to attend off-site strategy “retreats” and participate actively in strategy formulation together with management.

Despite their general involvement in strategy, and barring discussions on specific and critical new products or new technologies, boards often lack opportunities to discuss innovation strategy issues in detail, at least in a regular or structured way. One of the reasons is the fact that innovation strategies are not always formulated explicitly by management in a way boards can apprehend and rapidly assimilate, and this is true even in innovative companies. I have observed this personally in the course of extensive contacts with top management teams and boards throughout my career as an innovation coach and teacher.

Yet, as part of its strategy review mission, at the very least the board should ensure that top management communicates its views and intent in four areas pertaining to innovation, i.e.:

1. how it rates the strategic importance of innovation for its business and where it expects major innovations to emerge;
2. how that might change in the future in terms of intensity and focus, and what it means for the company;
3. how it plans to meet future market demands for more innovative offerings and for better and cheaper new products and services;
4. and more generally, how it plans to invest in innovation, not just in R&D, to boost its innovation performance.

But the board is entitled to go further and to expect management to communicate its actual priorities and provide an estimate of the resources the company is planning to invest by type of innovation. In my previous book¹, I suggested that management should recognize four broad generic innovation thrusts, each with a different impact on company resources and risk, and that it should explicitly prioritize its investments in each. These four thrust are:

1.  internal development of incrementally new and improved, ‘next generation’ products, processes or services;
2.  internal development of radically new categories of products processes or services;
3. development together with partners and/or ‘complementors’ of a radically new business model or system;
4. development together with partners and/or ‘complementors’ of incrementally new customer solutions.

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.

Reviewing CEO and management performance

A critical 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 for the replacement of the CEO. To do this, some companies have elaborated sophisticated formulas, resembling traditional balanced scorecard concepts in use by many human resource departments. CEO scorecards usually combine financial figures and targets – generally based on company growth, profitability and stock price, among others – with other qualitative or quantitative measures or specific goals pertaining to the company’s strategic initiatives and priorities, e.g. specific turnaround targets, progress in globalization efforts, capital efficiency improvements, etc.

Companies which depend on the introduction of critical, i.e. “make or break” new products – think of Boeing with its 787 Dreamliner – generally include the review of these large projects in the board’s deliberation. In these companies, the board is most likely to make the compensation packages of the CEO and the top management team contingent on the successful completion of critical milestones. But for many other companies with which I am familiar, 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.

This is why it is desirable, at least in innovation-oriented companies, to evaluate the top management team and the CEO also on the few innovation performance indicators that they will have suggested to the board as the result of their audit.

Managing innovation risk

Boards have a fiduciary responsibility vis-à-vis 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 at recognizing and addressing them. In certain industries and companies, other risks are regularly reviewed and assessed by the board, e.g. environmental risk and political risk. In some industries – e.g. the pharmaceutical industry – product liability and class-action risks are important subjects of board review. Rare, however, are the companies that identify the various types of risks related to innovation, and yet, these risks can, in certain cases, bring the company down – think of the fate of Kodak with the emergence of digital photography.

Part of the innovation risk may be internal, for example when the company bets its future on a totally new and untested technology or a risky and uncertain product concept. Managing this type of risk requires a sufficient understanding by the board of the two elements of that risk, i.e. the nature and level of the uncertainty and the exposure at risk. Recent experiences in the bank 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 their most innovative traders. In some banks, the board clearly did not exercise its governance mission in relation to innovation and new products.

Boards do not have to see the emerging trends by themselves, but their governance function requires that they ask management to keep the lookout and report to them.

The other part of the innovation risk is external and deals with the development and spreading of disruptive technologies by competitors that can make the company’s technology 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 consumer-appealing iPhone, in contrast to the professional 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 a constant attention by management on weak signals of emerging trends, and sufficient humility to keep challenging the company’s beliefs. Boards do not have to see the emerging trends by themselves, but their governance function requires that they ask management to keep the lookout and report to them. They must continuously ask ‘what if?’ questions while listening to management’s often reassuring strategy remarks.

I have so far limited the discussion to the traditional role of boards regarding risk, i.e. focus on the internal and external downsides of the company’s activities. However, in order to be innovative, a company has to take some risk and many companies fail to innovate because they will not take risks. Boards should therefore see their mission as stimulating management to take sensible risks to innovate, which brings us to a delicate part of the CEO evaluation issue. Indeed, if the CEO is being judged on stock price, this is usually a clear signal that management should focus on what will improve stock prices in the foreseeable future. In other words, and this affects the strategy issue, management will concentrate on incremental, non-risky projects in order to build market share and nibble away at the competition, but they will not focus resources on the longer term, less predictable projects.

Choosing a CEO with an innovation focus

The selection and recruitment of a new CEO, after the current CEO’s retirement – or his/her eviction – is undoubtedly one of the board’s most visible and difficult responsibilities. With the gradual reduction in CEO tenures, it is capturing a lot of attention by the business media.

In his book Bigger Isn’t Always Better: The New Mind-set for Real Business Growth², author Robert Tomasko introduces two opposite yet complementary management mind-sets, the “fixer” and the “grower”:

A “fixer” mindset is concerned with what needs to be done to maintain and preserve the business as it is, within the logic of its current dominating ideas. […] Fixers know how to maintain and improve existing operations. They are the drivers of today’s business model. […] They are quick to spot any divergence from the plan. Fixers mount search-and-destroy missions to eliminate excess costs. They speed the flow of product to customers by streamlining critical business processes. They launch company-wide quality improvement campaigns. They live in the worlds of six-sigma and TQM, downsizing and reengineering.

The “grower” perspective, in contrast, is focused on what is necessary to move beyond what currently exists. […] The grower’s model of the future is quite different. For them, it is not fixed or predetermined. Marketplaces, they believe, are constantly in motion, fundamentally open to new influences, and full of possibilities.[…] Growers believe that few trends keep going forever, and that small discontinuities in established patterns may be all that is needed to change entire industries. They relish discovering, or creating, these discontinuities. And then they make plans to take advantage of what is about to happen. For them, opportunities are abundant to create something new, and they are always alert for serendipitous events that can provide leverage for their plans.

When the grower’s mindset is employed, the business advances; when the fixer’s is used, it keeps afloat. Both are worthy objectives.

These attributes often apply to the CEO, and it is not unusual to see boards replacing “growers” by “fixers” whenever the company enters turbulent times, or when operational results start sliding downwards. This is what happened at 3M with the appointment of James McNerney, a talented “fixer” from GE, a nomination that several analysts considered a casting error for an archetype innovative company like 3M. McNerney then joined Boeing which badly needed a “fixer”.

Boards generally feel more comfortable with the more predictable “fixers” than with the innovative but sometimes more erratic “growers”. And yet, “growers” are often needed to challenge the status quo and embark the company into 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 privilege “growers” over “fixers” in their nominations, of course. But it means that they should put their nomination in context by considering the top management team, and 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 allow and support his/her colleagues as they defend an innovation agenda?

Are corporate boardrooms in need of education?

As I mentioned earlier in this article, the Malaysian Directors Academy seemed to recognize the board’s role in innovation governance when it started offering innovation workshops to its directors. This trend, if it is confirmed and spreads broadly, augurs well. In his Financial Times article under the above heading, IMD Prof. Didier Cossin³ argued for a change in board education programmes:

Most boards are not adding the value they could to corporations because they are not being educated properly. It would seem that business schools still see boards as a check on chief executives rather than as a competitive advantage for a company. […] Boards today can be a competitive advantage for companies. They can provide an outside view, overcome blind spots in strategy, raise awareness of external risks, connect with governments, society and other stakeholders, give credibility and build trust in ways that executive teams cannot. […] Consider boards and innovation. Boards not only monitor the company’s innovation performance, they actively contribute to it. Board diversity is key in this regard as board members from other industries are faster to foresee sudden industry shifts or disruptive moves. Employee representatives can also be an excellent source of innovative thinking. But again, how do business schools educate board members to perform this vital role?

Board education on innovation may therefore be needed to enhance innovation governance. But the question remains of the content of innovation programs for board members. How deep and how far should these educational programs go to allow board members to fully exercise their innovation governance mission without infringing on traditional management prerogatives?

By Jean-Philippe Deschamps

---

References

[1]   Innovation Leaders – How Senior Executives Stimulate, Steer and Sustain Innovation, (2008), Wiley/Jossey-Bass.

[2] Amacom (2006)

[3] Financial Times, January 9, 2012. Didier Cossin is professor of finance and governance at IMD, director of the IMD Global Board Centre and program director for High Performance Boards.