Fostering Innovation through Effective Risk Management

By: Adi Alon

Risk management can provide visibility, analytical insights and governance that can help companies better manage and optimize their innovation portfolio. In this article Adi Alon and Ken Hooper look at learnings from the VC industry and risk management practices to provide three principles that can drive higher return from an innovation investment.

Companies typically need innovation to grow.  While companies recognize this, many have established environments that discourage, rather than encourage innovation.

The concept of “stage gates” – essentially a series of funnels designed, in theory at least, to identify and advance the best innovation ideas – can reduce risk while accelerating innovation.  In practice, the way that the stage gate process is applied often results in  the opposite effect.  Without sophisticated risk management capabilities, the stage gate process can eliminate big ideas in favor of small ones and result in a portfolio consisting of small, low risk, incremental ideas.

Based on the learnings from the VC industry and risk management practices there are three principles that we observed that can drive higher return from an innovation investment

Instead of a fast, agile process, some companies wind up with a slow, linear grind that rarely contributes to meaningful growth.  These companies can also be hampered by backward-looking tools that are inadequate for identifying the real value of an innovative idea.  Net Present Value (NPV) models, for example, are designed to make market projections but typically do so by looking at recent trends.  This can push companies toward optimizing their existing product lines through extensions and incremental improvements.  The focus on the recent past can cause companies to miss potential large changes in the market and the opportunities that may result from such shifts.

Our research and our own experience with helping companies encourage and accelerate the innovation process indicates that many organizations would be better served by applying risk management tools and approaches in managing their innovation portfolio. Risk management can provide visibility; analytical insights and governance that can help companies better manage and optimize their innovation portfolio.  One industry sector that is skilled in managing and investing in a high risk environment is Venture Capital (VC).  VC firms typically create a portfolio of investments and use the insights gained from each experience to manage the experiments as a group.  Also, VC firms boast of their “skill to kill”, i.e. their ability to move quickly away from investments that aren’t working.  One or two successful VC investments can earn back the cost of the entire portfolio – many times over, in some cases.

Based on the learnings from the VC industry and risk management practices there are three principles that we observed that can drive higher return from an innovation investment:

The first principle is flexibility.

Just as some investors use put and call options to build a flexible portfolio before knowing which investments will pan out, companies may want to consider building a portfolio of early innovation investments that act as options.

The second principle is control.

Venture capital firms use controls, but these controls are often designed to achieve the opposite effect that they do in most corporations.  They are typically intended to increase risk tolerance by creating a culture that embraces the logic of intelligent mistakes and bridges two organizational mindsets that are often at odds: finance and operating units.

The third principle is speed.

Companies can use rapid experimentation and agile development to increase their chances of filling new innovation portfolios with new products and extensions, with the risks well-managed.  As an iterative approach closely linked to customers and markets, agile development may draw attention to risks and integrate such risks into decision-making.

Executives around the world are focused on growth strategies, their associated risks, and risk management capabilities. Programs that accelerate innovation are becoming more common, in part, because successful innovation can be the cure for many risks companies face. Risk management has moved forward at the same time because of its potential to provide controls in complex business environments.

Risk management can add a level of discipline and transparency while supporting the desired risk culture and appetite. To fuse innovation and risk management processes in a way that unleashes innovation in a disciplined way, we believe companies should consider establishing these guidelines:

1. Culture.  Recognize that small failures are acceptable as long as they occur within defined risk tolerances.
   
2. Oversight. Provide lean risk and innovation governance and processes in an effort to support investment decisions at a rapid pace.
3. Business model.  Map how company strategies, upside and downside uncertainties, risks and innovation activities are related.
4. Analytics. Use risk measurement and scenario analysis techniques to better understand individual risks, combinations of events, and unintended consequences, including the risks of under-investing.
5. Innovation Portfolio.  Align your innovation portfolio with company strategies and top risks with a goal of maximizing the potential benefits from investments.
6. Innovation Processes.  Focus your innovation process on speed in an effort to shorten learning cycles; recognize failures early and make timely course corrections.

Although counterintuitive to some, we believe organizations that leverage their investments in a risk management structure and techniques have an opportunity to improve to improve their innovation results.  How is innovation risk managed in your organization?  Does risk management encourage or impede innovation?

By Adi Alon and Ken Hooper