Why Companies That Are Great at Innovation Still Fail - with Stanford Professor Charles O'Reilly

0:00The average life expectancy of a company in the Standard & Poor's 500, I think, in the next couple of years will be around 12 years. So what that says to me is that the leaders of these organizations are not adapting and helping their organizations survive a long period. We've seen companies be very good at ideation and incubation and fail. And the reason I fail is that the third discipline is scaling. Once you have a validated idea, can you actually make sure that it gets the resources it needs to actually grow and take off? Hi, I'm Charles O 'Reilly, and I'm on the faculty at the Graduate School of Business at Stanford University.

0:42I've spent the last few decades actually trying to understand why some organizations succeed in the face of change and others don't. And I'm looking forward to having a conversation about that and really about what it takes to both succeed in your existing business, to exploit existing capabilities, get better and better, but also to leverage those into more exploratory activities. And so I'm excited to have a conversation about that, and especially the role of artificial intelligence as it affects that.

1:13Jeremy:Man, I am so, may I just say, I am really excited about this conversation. This is going to be a lot of fun. So Charles, maybe we could just start with this. The phrase explore and exploit has come up a bunch. It probably, I don't know, Henrik, what? Eight times in conversations, right? It comes up often. And we thought it would be really special to have a world-leading expert on innovation strategy come and talk about, not about AI, but about what do we know from decades of research about how to help organizations innovate. And so we're delighted to get to talk to you and just thought maybe you could start with a brief introduction to what does it mean?

1:56Jeremy:What does Explore Exploit mean? Why is it different? And why do organizations struggle with it? Yeah. So the term Explore Exploit from an academic perspective was really came from a fellow named Jim March, who was a professor here at Stanford. And he wrote a paper in 1990 that that really talked about the problems that organizations face because when they get good, they get better and better at doing what is making them successful. And he refers to that as exploit. You know, we're getting better and better at our existing customers, our existing technology, existing manufacturing. But, of course, when the world changes, then it requires organizations to do very different things.

2:39And that is to, you know, to look into the future, to try things, to experiment, to maybe fail, go down blind alleys, come back. And he refers to that as explore. What that has come to, I think, mean for people who study organizations is exploitation is really leveraging your existing assets and capabilities. It's doing what is making you successful, better and better, incrementally improving. exploration is really about what you all are experts in, which is sort of innovation and coming up with new ideas and testing new ideas. And the difficulty that organizations face is that the very things that make them successful in their mature or exploit business, the metrics, the incentives, the skill sets, the culture, the very things that help them be successful in their big mature business really work against trying the things that you need to do in a world that's changing to explore.

3:46And so that's the tension that explore and exploit captures. I was studying a company in China that did an interesting thing, I thought, because a A lot of the companies we talk to when it comes to AI, they talk about AI as a for for the mechanism of saving money. Right. It's making more efficient, fewer people. What this company did was that they found a way to really measure like how much money they save with AI. And then they allocated the same amount of money into doing exploration. So they built venture studios or all kind of hackathons around that. And why do you think that so few of the companies that are currently thinking about AI are thinking about it in both an exploit and an explore kind of way?

4:37Why lean to the exploitation? You know, so you all are experts in AI, and of course I am not. But as I think about AI, I think about it can have two very different types of effects on organizations. You can think about the substitutes and complements. That is, AI can substitute for existing processes. So if we look at, for instance, law firms or consulting firms, AI or accounting firms, AI is helping them do a lot of the work that used to be done or had to be done by people. It can be done now with AI. That is, in some ways, a substitute. A complement is it helps you do things, your existing things, but it helps you do them better.

5:27And so I think many organizations, and personally as well, I don't think we quite understand whether AI is going to be a substitute or a complement. And in some instances, of course, it could be both. But the organizational response to substitutes and complements, I think, are quite different. If AI is substituting, if it's doing things that existing people processes did and it's now doing that, that suggests that you may need to be more exploratory. If it's a complement, it's just helping you do things better, then it requires change, but it doesn't fundamentally alter what the organization is doing.

6:14Think about something like drug discovery and the use of AI in drug discovery. That is a substitute, I think. That is, if we're in a big pharmaceutical company and we've got a bunch of computational chemists and we've been doing sort of drug discovery, and along comes AI that can do protein folding, and, you know, that's different. And we probably need a separate unit, more exploration. So it is complicated. And I don't think many organizations, Enric, I don't think they quite know yet which of those two things it is.

6:51Jeremy:Now, if you kind of set aside AI, so forget AI or just squint your eyes, it's just a technological change. We've seen this show before, right? And you've seen it, Charles, you know, many times over the course of studying organizations. I know that adaptability is a key piece of this puzzle. Can you talk about adaptability as kind of a virtue and how do organizations cultivate the ability to adapt to change? Yeah. So you're right. I mean, adaptability is high on the agenda of many senior managers nowadays. The way I think about adaptability is really from a cultural perspective. That is, to step back a little bit, if you think about culture not as something vague, but as a social control system in organizations, that is sort of expectations about how you have to behave to fit in and be successful.

7:46So if you think about culture as something much more manageable, concrete, then the question of adaptability becomes, well, what is a culture that would promote adaptability versus a culture that would not permit adaptability? And a culture that promotes adaptability is a culture that encourages flexibility, encourages initiative, encourages some risk-taking, and by the way, has the support of those things. But it's a set of norms and expectations that say, yeah, you know, you ought to be in your job, whatever your job is, you ought to be experimenting. You ought to be trying things, seeing if you can get better.

8:26Of course, in big, successful exploit organizations, the culture is very different. The culture is sort of incremental improvement, compliance, you know, do things the way we've always done them. It's kind of kaizen in the Japanese context. And so one of the problems with adaptability is, I think, if you're going to promote adaptability in an organization, then it's partly a cultural play. It's partly a leadership issue. Henrik, the Chinese company you're talking about, is very interesting. I think leadership saying, by the way, we're going to measure this and then we're going to allocate resources to exploration.

9:10That's a leadership play. But it's also a cultural place. So I think adaptability is, in the main, cultural. I feel that Jeremy and I meet a lot of people who have an AI role in our organization. And there seemed to be a frustration sometimes from these folks, but also sometimes from the very senior management, of the lack of kind of like interest in this new technology. And I think from people across the organization, there's a little bit of like, yeah, but this is something that's really dangerous to me because if I became really good at this, I might even be able to show that my role is not,

9:55Jeremy:can be done with this technology. Have you seen that dynamic before? And is there like advice on how to tackle that? And so that's, you know, I think that's classic resistance to change. And it could come from AI, but it could come from lots of other things as well. And so, I mean, one of the things that happens, as you know, in organizations is I get better and better about my job and I learn how to do it. And then something comes along that says, oh, by the way, you could do your job more efficiently or in a different way. And, you know, my identity is wrapped up in this, my livelihood, my status in the organization.

10:36So resistance to change, I think, is common for lots of reasons. And AI, I think, is just the latest thing that kind of makes people anxious about it. And, you know, you could have a whole separate conversation about how, and there are people who study this, how you overcome resistance to change. And, you know, there are some tools and techniques that you can use to do that. But I think, Hendrick, to answer your question directly, I think the resistance to change from AI is the same as the resistance to change for lots of things.

11:09Jeremy:And what have you seen as successful strategies for organizational leadership tactics to help folks overcome this resistance? Do you just need new people or is there something you can do with folks who are resistant to help them? Again, this is a little out of my expertise, but first of all, it's a leadership issue. If senior leaders are not encouraging people to try new things and do the sorts of things that Hendrick talked about, then people deeper in the organization have a reason not to be enthusiastic about change. So in the first instance, I think leaders have to signal this. you know I mean we see senior leaders oftentimes sort of doing the things that they want other people to do that's a very powerful if I'm deep in an organization and I see my senior leaders trying something new then that says to me well this is important and I should probably do this if I hear them talking about you know you ought to be trying new things but I don't see it And it's harder for me to do that.

12:18So I think being explicit about managing change is important and senior leaders designing programs to implement change. You know, if we could go off on a long tangent here, but one of the companies that I think has done a terrific job of managing change over the last 10 years is Microsoft. And if you look at how Nutella and Kathleen Hogan, who's their chief people officer, if you look at how they manage that shift from office and servers and windows to mobility and cloud, it's a masterclass in how you overcome resistance to change. What have we seen at Microsoft? I'm not familiar with that, with the internal tactics.

13:05Jeremy:I'm familiar with what we see from the outside, but what do you know about what they've done? So partly it was a huge culture change. I mean, so they changed the strategy. Nadella said, we're going to move from office windows servers to mobility and cloud. He did a bunch of symbolic things like he embraced open source, which Balmer and Gates, Balmer actually said open source was a cancer on intellectual property. So from a leadership perspective, he changed the strategy. He changed the structure. He reallocated people in the organization away from Windows. He quit talking about Windows, started to talk about cloud and mobility.

13:46So at a leadership level, they did a bunch of things. But they also collected a lot of data. They got people involved around the culture. And then, you know, they asked people around the culture. They said, what is it about the Microsoft culture that has made us successful that we want to keep and preserve? What is it, if we're going to be successful in mobility and cloud, what is the culture? What are the norms? What are the behaviors we need to be successful? And what are the norms that we have now that might stop us? They collected a bunch of data, and then they had a big offsite, 180 senior people, And they decided on this notion of growth mindset as this kind of overarching meme or metaphor.

14:30And they decided on a bunch of behaviors that were characteristic of a growth mindset, of taking risks, of doing things differently. And then what they did, which I find quite remarkable, is Kathleen Hogan, their chief people officer, she put together a little training program that helped managers at different levels. Think about what growth mindset was, what the behaviors are, how they can implement it. They trained 27 ,000 managers. They drove it into the organization. They changed the performance management system. They changed the training system. It's really a complete transformation, which, by the way, we're now writing cases on some Japanese companies that are transforming themselves.

15:16And we're seeing a very similar sort of approach to how you overcome resistance to change with some of these Japanese, successful Japanese companies. Do you think that resistance to change is really the headline for why companies increasingly are, you know, not growing? I mean, like I've read this thing about how in the 60s, a company would be in the Fortune 500 for 67 years and now it's 18, expect to be 12. Is that changing? Is that the thing that they're not able to do? Yeah, I mean, that's one of the clear indicators of why some organizations are not adapting. I mean, you're right. The average life expectancy of a company in the Standard & Poor's 500, I think, in the next couple of years will be around 12 years.

16:04And so if you think about what that means, what that means is previous great companies are becoming less and less relevant, or they're being replaced by other companies. Or in some cases, they're actually going bankrupt. And we see the rate of bankruptcies is increasing around the world. The rate of bankruptcies is increasing. So what that says to me is that the leaders of these organizations are not adapting and helping their organizations survive over a long period. Now, of course, there could be some organizations where, you know, they're just they don't have the skills and assets and they probably ought to go out of business.

16:42But most organizations have have assets and capabilities that they if they were smart, they could apply to in these new ways and move into growth markets. That's the core of what we talk about when we talk about ambidexterity, the ability to explore and exploit. It's the ability of leaders to compete in your existing business with the alignment that it takes to do that, but to simultaneously leverage assets and capabilities into new growth areas. And for me, those are the most interesting companies. If we look at the different methods for doing the exploration, we talked a little bit about the Chinese company that took kind of newfound gains for the AI and put it into hackathons.

17:30We mentioned Microsoft's that really understood how to change a culture. I know you spent some time on Cisco. My understanding there is that they were very good of basically investing into staff members that then spun out and created something and then they bought a lot of them back at one point. And then to go into completely different end, you have the SEAL team in the U.S. that reports straight to the president. And then you have the new foundational models that sold themselves as research laboratory. And so if we think of that structures define the outcomes and that we need architectural new kind of concepts for us to figure out how we go from being exploiting companies to exploiting companies, what would you suggest to people who sit and are trying to kind of pick a path?

18:16if that is kind of just a little bit of the Pele. Yeah. So that's a big question. So to go on a slight tangent, as Jeremy knows, we had the privilege of working with Jeremy and others over in the design school for years now with some of the executive programs that we run. And that really triggered a meme because I saw how powerful their design thinking could be. And it really triggered in me, well, you know, ideation, coming up with new ideas is very important. And, you know, there are methodologies like open innovation, design thinking, CBC, hackathons. There are a bunch of methodologies to do that.

19:01But that's not enough. I mean, you have to be able to take these ideas that look promising and validate them. And that's what we call incubation. And, you know, again, we have methodologies to do that. I mean, you, Hendrick, you know about this with Venture Studios. We have Lean Startup. We have a business model canvas. We have a bunch of ways doing that. And we've seen companies be very good at ideation and incubation and fail. And the reason I fail is that the third discipline is scaling. That is, once you have a validated idea, can you actually make sure that it gets the resources it needs to actually grow and take off?

19:43And we've seen that in our experience. That's where many organizations fail. Because when the time comes to begin to shift assets and capabilities from existing profitable, but perhaps declining businesses into new growth businesses, that's where leaders often get very nervous because it affects profitability and the like. So it's the scaling part, I think, that makes a difference. And in order to scale, especially when you have substitutes, you have to have separate organizations. Because if you try to do it within the existing organization, it inevitably gets crushed by the weight of the existing.

20:26Let me give you an old SAP example. So we had a chance to study SAP back in the early 2000s. What SAP at the time realized was that the global market for their big$20,$30 million enterprise resource planning systems was flattened and going to decline. And so the CEO at the time said, we got to get into growth markets. And the growth market was small and medium-sized business. That was a software as a service play. And they had a good product or a reasonable product for that market. But they didn't set that up separately, and they tried to run it with a cross-functional team within the big functional organization.

21:13And what happened predictably was, you know, the pressures on selling ERP systems, the revenues from ERP systems, the incentives, and indeed the culture that rewards ERP systems was different. And so they failed. They ultimately, what they did is they spent$11 billion. They made a bunch of acquisitions to get into this software as a service business. You know, they're doing fine at it today, but they failed basically because they didn't set up a separate business. And that's the pattern we see. Most companies, I mean, you all have experience at this. Most companies, I think, today understand the importance of ideation and incubation, and they understand how to do it.

21:56They often invest in it. The trick is to really scale. I very much echo that. As I mentioned offline, I wrote a book called The Acorn Method about our experience in building corporate incubation. And I think exactly what you just said was often the issue. we could incubate businesses and get them to a million or two or$5 million in run rate revenue. And then I think, iconically, you would go down to the CFO and saying, I'd like another$10 million to scale this. And they would like, and for this non-profitable thing that you want to take money off my balance sheet? Like, no way. And so that, what we call the A-round crunch, which was really very easy to do in the venture world, but very complicated to do in the car world.

22:40Yeah, exactly right. Exactly right. We saw a couple of companies, one big American company and one big German company came up with, they did the ideation incubation. They came up with potentially really interesting products. They did the ideation incubation. Then they moved them into the existing lines of business units. And exactly what you said, Hendrick, when the time came to say, well, okay, if we're going to scale this, we need more resources. And the big business owners looked at it and said, well, wait a minute, that's a lower margin business. It's not clear that we're going to get the returns on it.

23:19If I take that same money and I invest in my existing business, yes, it's under pressure. Yes, it's declining. But I can squeeze out margins and I can make my numbers. And so that's exactly what we see happen.

23:33Jeremy:Have we, I don't know, this could be a dead end, but have we studied NVIDIA, Charles? I mean, the scale of their growth and the kinds of new businesses, I mean, I heard they have a, I can't even think what the business is. They've got a new business that's doing, you know,$40 billion or something. It's kind of come out of nowhere, right? Do we have any sense for what the mechanisms are or what the expectations are within NVIDIA to drive that kind of growth at that kind of scale? Yeah, short answer is no. I mean, we've had some people from NVIDIA come in and talk to classes, and they're clearly very successful.

24:11They've got huge amounts of resources. I'm always, not to take anything away from NVIDIA, but I'm always skeptical. When companies have huge resources, they can do lots of things, and they can try lots of experiments. You know, it just allows them to do things that other companies can't. I'm not sure that's sustainable over the long term. I mean, once the profits return to normal levels, now you're back into the dynamic that we've been talking about. For me, the company that is, in some sense, the best example of a company that has figured out how to do, explore and exploit is Amazon. You know, Amazon, if you think about what Amazon has done, And they're 1994, one employee, zero revenues.

25:03This year, they're going to be 700 plus billion dollars and 1.5 million employees. And if you look at how they've done that, and they're on all these businesses. I mean, they sell everything online, but they're also in movie production. They're in healthcare. They're in satellites. They're in autonomous driving. They're in, you know, all sorts of things. And they have a process that constantly allows people to come up with new ideas, what they call the PRFAQ process, which you may be familiar with, where anybody can come up with an idea, but they have to do it in an exceedingly rigorous way. They have to come up with a press release and frequently asked questions.

25:44If that idea is accepted, they immediately get some release time. They're set up as a separate team. They get engineering support. They're constantly doing, they do hundreds, if not thousands of these experiments every year. Most of them fail. Oh, that's okay, because they're small. I mean, Bezos says, and I think he's exactly right, ideation and incubation are cheap, especially for big organizations. Small teams of people doing experiments, not very expensive. It only gets expensive when you scale. When you scale, that's when you're going to spend the big money. So I think Amazon is a lovely example of a company.

26:30It's partly a cultural play. It's partly a leadership play. It's partly a structure plate. It's a process to constantly set up new businesses.

26:39Jeremy:That's a perfect example. I mean, I'm a huge fan of what Amazon has done. I think there even take something as simple as a PR FAQ, the fact that any employee can basically make a proposal for a new exploratory project and immediately get released from their job if they get permission to do it. Most organizations go, no, but she's a great analyst. You know, we don't have any more great analysts. You know, the number of times I've seen that is just staggering. Yeah. So my favorite Amazon example, which I think is real. I mean, I asked a couple people and they said, yeah, it's real. There was a clerk in the accounting department that was processing accounts receivable.

27:21This is many years ago. And he noticed that there were individuals buying large quantities of office supplies. Thought that was odd. He looked into it, and it turns out these were small business owners who were buying business supplies for their businesses. And so he came up with a PRFAQ. They gave him some release time. It turns out it was a business. Today, this is called Amazon Business. And the last I checked, it's a$40 billion a year business. They do this constantly. AWS came because they re-roped the software. This was back in the early 80s. They rewrote their software to make it easier for other companies to sell on their platform.

28:06And some smart person realized we have excess capacity. We could sell computing infrastructure. So to quote my colleague, Bill Barnett, Bill Barnett says the job of a leader is not to predict the future. It's to design an organization that can discover the future. And that's what they did with AWS. They did not predict the future. They have a process where they discovered it. And to your point, they probably also have a culture that would allow, because I could imagine many organizations where you come in and you're a book e-tailer and somebody says, we're going to rent out servers. Somebody's going to go, well, you should focus.