Innovation through "venture capital" in DoD's Working Capital Fund organizations: generating new ideas and turning ideas into revenue - WOF - Entrepreneurs, Innovators

"...The last bastion of Soviet-style central planning can be found In Fortune 500 companies--it's called resource allocation."

Gary Hamel

Bringing Silicon Valley Inside

Of the largest 100 firms in the United States a century ago, only a handful exist today in y form. Various fates awaited em on the road to oblivion--mostly bankruptcies and takeovers. Given enough time, successful firms will usually fail because they become irrelevant, their products and services surpassed by far better offerings. They move too slowly to keep up with the market.

The Need Innovation

Peter Drucker, in his article "The Discipline of Innovation," published by Harvard Business Review in 1998, defines innovation as "the effort to create purposeful, focused change in an enterprise's economic or social potential." The history of American business makes it clear that sustained innovation is a prerequisite for an organization's long-term success and its continued existence.

Within the private sector, the language of business is peppered with terminology such as merger, acquisition, and bankruptcy. Within the Federal Government, the counterparts to those terms are reorganization, RIP [Reduction in Force], and BRAC [Base Realignment and Closure]. As in industry, government organizations close shop when there is no demand for their output; it happens at a slower and less dramatic pace than in the private sector, but it happens nonetheless.

Generating new ideas and turning the ideas into revenue is a primary characteristic of firms that stay healthy over decades. The quick pace of technology continues to shorten product life cycles, so faster innovation cycles become increasingly important. A good product pipeline is essential, and companies like Kodak, Digital Equipment, and General Instruments that fall to sustain innovation show the way to insolvency But do government Working Capital Fund (WCF) monopolies (for example, the Naval Undersea Warfare Center, the Defense Logistics Agency and the Air Force Transportation Command) face similar risks of irrelevance? Certainly!

In some of our organizations, more than half of the 1990 workforce is now gone. The trend is outsourcing, where industry designs and develops almost all military platforms and systems, industry funds and conducts a higher percentage of research, and full-service contracting will dramatically reduce the need for government logistics and maintenance personnel. Contractors, not government technical experts, will accompany the warfighters into harm's way. The handwriting is on the wall for many WCF business units, largely because of our inability to innovate and keep up with the private sector.

(The DoD's WCF organizations operate much like private firms, except that turning a profit is not allowed. Through marketing and sales of services, we generate revenues, which in turn pay salaries and other expenses. If revenues drop, expenses must drop by the same amount. This is in contrast to headquarters, program offices, etc., that are "mission funded" directly in the defense budget.)

The illustration on p.__(published in Leading Product Development by Wheelwright and Clark, 1995) depicts the innovation funnel that all organizations must manage to stay competitive over the years. Firms can fall down at any of the stages of innovation, but this article focuses only on "idea generation"--the stage at the mouth of the funnel. Regrettably, It is also a stage at which many large organizations within the Federal Government fall short.

In recognition that our innovation in computing and information technology lags behind the private sector, for example, the Pentagons Director of Force Transformation is floating "venture capital" projects to provide start-up money for technology firms with good ideas. In the parts of the DoD financed by the Working Capital Fund, "venture capital" programs hold much potential to spur ideas internally.

What is Venture Capital?

To be successful, innovation requires not only ideas but also money (i.e., capital) and talent to develop the ideas. Most entrepreneurs cannot finance the business themselves, so they seek capital from a variety of sources. Banks (i.e., commercial lenders) are an important source of start-up financing for new businesses. However, businesses are unlikely to receive bank loans if they lack hard assets (land, buildings, and equipment) for collateral: have large degrees of uncertainty about their future: or will suffer several years of losses prior to earning money.

Venture capitalists accept the high risk of start-ups, but they demand ownership of a large portion of the firms and strict control rights in return for contributing their expertise and a relatively modest amount of money Entrepreneurs often resist these controls, striving to retain ownership at all costs. They often have little choice, however, if their idea is to be incubated and brought to life. Unfortunately great Ideas often make slow progress without outside capital infusions.

Banks tend to approve one-third or one-fourth of loans requested by established companies, but venture capitalists approve only one out a hundred of the proposals presented to them. Of 10 investments made by a venture capitalist, five may be total write-offs, three may be modest successes, one will double the initial investment, and one will return the investment 50- to 100-fold. Making sure you have a big winner is the goal--not making sure there are no losers. This philosophy runs contrary to the DoD's risk-averse culture.

Discipline is critical for venture capitalists, and any "venture capital" program in the DoD must evaluate ideas with equivalent discipline, even though finance and other business skills are in short supply in the DoD. Even in the private sector, venture capitalists have low rates of return when they tend to take bigger risks and accept lower returns because they feel that the entrepreneur's Idea is attractive for "non-financial" reasons. The necessary discipline Includes a dry-eyed look at expected revenue--the most important measure of a project's value.

Reward Your Innovators

Your organization's working level, which not surprisingly contains most of your workforce, has almost all of the potential ideas for innovation. These people are much closer to the technology and warfighter (and to market opportunities) than are upper- or mid-level managers. However, the risk vs. reward trade-off for potential entrepreneurs in most organizations is long on risk and short on reward. Few employees will risk a bruising battle with the defenders of the status quo when our potential payoff is so meager.

The current environment for DoD employees clearly offers only scant incentives to innovators. In many cases, your innovators see a long struggle ahead to win over the bureaucracy--and give up before starting. No wonder few ideas emerge.

Barriers to innovation need to come down, and motivators of innovation need to go way way up. We want performance awards, visibility career mobility and progression, promotion, novelty, impact, meaning, exhilaration, wealth, and freedom to run our programs, among other things. Entrepreneurs get all these in, for example, Silicon Valley "Entrepreneurs" in the DoD get almost none.

Money and control of one's destiny are extremely strong motivators, if Silicon Valley is any example. Employees have to believe that the best way to win big is to be part of building something new. That means providing additional incentives for employees who are willing to lake a risk on something out of the ordinary. It's not enough to remove the barriers--we must positively provide incentives for employees to abandon the familiar for the unconventional.

We, In the DoD, should strongly consider privatizing entrepreneurial teams and giving innovators the chance to become wealthy through their own companies. Spinning-off small parts of the DoD's field activities could be highly motivating to some of the workforce.

But even if a "venture capital" program does not lead to privatization, it provides another source of funds to our budding entrepreneurs, another set of ears to objectively consider the idea, and another option for funding. The pro gram should provide ideas an easy stroll to acceptance, vs. the uphill struggle and war of attrition they now face.

Innovation Through Venturing Capital Market

The market for capital in Silicon Valley is nothing like the market for capital in DoD or any other large organization. In a large firm it is almost impossible for someone seven layers down to get a couple hundred thousand dollars to try out a new idea. Capital budgeting at high levels and aversion to risk eliminate any chance that ideas at the working level will be funded in a timely way--but market-driven creativity cannot depend on an annual budget cycle. Pots of money must be "prepositioned" to quickly get the ball rolling whenever ideas are identified. The discipline mentioned earlier means that in years with few good ideas, most of the prepositioned funds get returned to the sponsor.

Top-down resource allocation, and the painstaking financial analysis that underlies it, do have a place in companies and within DoD. It can't be the only game in town, however. Its vitally important to manage the downside risk of big investments in the core business. It's equally important to unleash the ideas and passion that will create new businesses or transform the core.

Large amounts of money are not necessary to create enormous value. In the United States, the average first-round investment for a start-up is $500,000. This is for companies that inside of a decade can be valued at over $1 billion. In WCF organizations, a good project should attract multiple investors from within the organization. The $500,000 average first-round investment would ensure significant progress; most projects would need far less to start up.

In the private sector, venture capital investors often get a large percentage of the gains (for example, 20 percent) for a finite period of several years, and then the start-up has to pay back the original investment (usually by going public). Venture capitalists might risk 1 percent of the money and get 20 percent of the gain. The internal rate of return of the average venture capital firm is estimated to be about 40 percent. High returns are appropriate for the high risk involved, whether the venture is in the DoD or the private sector.

Depending on the format chosen, the term "venture capital" might describe DoD programs incorrectly. Funding could be provided simply through internal "loans" (e.g., a funding document from one department to another and an agreement to repay under certain terms). However, this "commercial loan" format includes implicit or explicit guarantees of repayment that are inappropriate for venture efforts: the idea is to motivate the lender to promote the project and lend talent, ideas, and experience to the effort. "Commercial loans" don't do this.

(Note that if the "commercial loan" model is used, the question of collateral must be addressed. If a project is disappointing and expected revenues do not materialize, the "commercial lender" should have rights to assets such as equipment, vehicles, etc., of the borrower.)

Collaboration between the lender and entrepreneur is more likely if the guarantee of repayment is eliminated. Strengthening the financial incentives for a win-win situation should improve communication, teamwork, and relationships. Our lenders need to have a strong interest in seeing the project succeed--in other words, they should lose their investment if the project fails.

To strengthen teaming between branches, etc., and to create a vested interest on both sides, an investment of $100,000 might require 25 percent of revenues (not principle) be paid to the lender for five years. Failure to generate revenue means the investor loses money; conversely a hot-selling product makes money for both the lender and entrepreneur.

Specific terms of each transaction are negotiable--a true capital market would not allow monitoring for "fair" agreements. Business acumen will be rewarded and strengthened. Clearly estimates of revenue and the underlying assumptions will be critical for thorough financial analysis to support investment decisions.

Idea Market

Silicon Valley is tapped into its workforce's creativity like nowhere else. An average-sized venture capital firm in Silicon Valley gets as many as 5,000 unsolicited business plans a year. How many unsolicited business plans does the average senior vice president of a big company get? Five? Ten? Zero?

A constant supply of ideas is critical to venture capital. One could easily argue, however, that our flow of ideas from the DoD's WCF organizations and laboratories is a mere trickle. Instead of creating, we focus only on hammering down costs and outsourcing inefficient processes. Few would disagree that we are in a stewardship mode vs. an entrepreneurial mode, and that the current goal is to get better at what we are already doing. Operational efficiency is the focus.

Being innovative is the exception in the DoD when it should be the rule--an impossible situation to reverse without a market for ideas. This won't happen until large incentives are offered to those who are creative.

Talent Market

The lack of a low-friction "talent market" within our commands will hurt innovation. In Silicon Valley 20 percent employee turnover is the norm as the most talented move to wherever the most intriguing innovation is occurring. Very few DoD managers will encourage or even allow our best talent to up and leave for six months, especially if the temporary reassignment Is to a "competing" organization.

Civilian managers tend to feel ownership" of their subordinates and want them to continue in their present Capacity regardless of the employee's ambitions or need for rejuvenation. However, creative and ambitious people trapped In a box will leave-better that they are offered the chance to do something different within the command. Unfortunately managers often put their parochialism above the better good, even though they know that the marginal value a talented employee adds to a business running on autopilot is often a fraction of the value that individual could add to a venture not yet out of the proverbial garage.

Innovation and new ideas tend to come from new voices, so the constant movements of people (i.e., voices) within and between commands will only fuel innovation. Shell Petroleum is an excellent example. According to a Shell manager, "Jobs are listed on Shell's intranet, and with a two-month notice employees can go and work on anything that interests them. There are no barriers hindering people from going to work on whatever fires their imagination."

A Monsanto manager said, "Because we don't have a lot of structure, people will flow toward where success and innovation are taking place. We have a freemarket system where people can move, so you have an outflow of people in areas where not much progress is being made."

Private sector corporations often initiate internal "venture capital" programs to spur innovation, where a stated goal is to spin out the new businesses as new companies. Firms spun-out into separate companies are usually controlled by the parent company through stock ownership. This prevents the new company from competing directly with the parent, yet frees the new company from the bureaucracy of the parent and allows the new management to focus more intently on market opportunities. This approach to innovation provides strong motivation for idea generation and internal entrepreneurs-in a word, it's a way to get rich.

Corporate Examples

Opportunities exist for DoD to follow the same model and spin-out small, cutting-edge, innovative businesses, but lawyers first need to explore the legal environment; significant changes to statutes would probably be necessary. Initially the spun-out companies could be owned partly by the government--a situation with ample precedent in most countries today and in U.S. history

Some will argue that America's push to shrink government and consolidate the defense industry flies in the face of creating state-owned enterprises. In reality it is an interim step to shed parts of the DoD while invigorating the marketplace with nimble, entrepreneurial niche players. If equity ownership and control of the new firms are not required, contracts and outright grants can provide the funds to spin-out firms: the U.S. Small Business Investment Company and Small Business Innovation Research programs are relevant models.

Historically corporate America has perceived venture programs as inviting because corporations, like DoD, extract only a fraction of the value that their Research and Development laboratories generate. Many of the best ideas languish, unused, for a variety of reasons. (A good example here would be internal resistance to compete with existing products or an inability to take advantage of the initial insight.) Venture programs are viewed as an attractive means to get good ideas to the market. Though companies are not required to report efforts in this area, it is estimated that almost all Fortune 100 companies have venture programs.

WCF "Venture Capital" Programs

A formal process is needed to get our entrepreneurs together with our capitalists. Each level of the organization (Division, Directorate, Department, and Branch) should be able to seek both funding and investment opportunities.

Setting up an office to focus on "venture capital" is a small price to pay considering the potential payoffs. However, failing to dedicate personnel--at a minimum a part-time panel of experts and "entrepreneurs" who will advocate innovating, funding the best ideas, and coaching the development of action plans--can doom such efforts before they really begin. These dedicated individuals should not be drawn from the ranks of those currently approving resource allocations like military construction, equipment, etc. This would give unorthodox ideas a better chance of being funded.

Defenders of our old business model should not have veto power over new business models. Often, new ideas get squashed for no other reason than that they threaten to cannibalize the revenues of an existing business. For this reason, ideas should not flow up through any managers: ideas should be submitted directly to the team.

Nobody can assume that the next great thing will come from an upper manager running the last great thing. Excusing the vast majority of a workforce from the responsibility of strategic thinking is commonplace, yet tremendously wasteful of talent because those at the top typically are unlikely to generate truly revolutionary ideas. Therefore, the program should be aimed at the working levels (i.e., below GS- 13), where the majority of workers and ideas reside.

Encouraging innovation is the primary goal. The toughest problem will be to get our people to submit their ideas. Precious few hoops should be placed in front of prospective "entrepreneurs" to jump through before they receive money. A robust business plan, thorough projections of revenue, etc., are not necessary at the initial stage and would only deter those with ideas. Dedicating a half of a percent of revenue annually to pay passionate people to explore 10 or 20 unconventional ideas, build prototypes, try new logistics approaches, etc., is peanuts.

For ideas that are not funded or for funded projects that go nowhere, the culture must show appreciation for the attempt. The U.S. economy is robust partly because bankruptcies do not prevent entrepreneurs from starting again; in most of the world, entreprezneurs get only one chance. If we want lots of new ideas, let's reward them.

Get Radial

A persistent, yet unfounded belief pervades our nations business culture: that big organizations must always lose to nimble start-ups. In theory, it should be easier for large companies to re-deploy resources into new areas than for start-ups to plead for funding and Induce prospective employees to endure the hassles of changing companies.

Continuous innovation over decades is a prerequisite for long-term existence, but the culture in most WCF organizations fights innovation. A "venture capital" program is one step toward transforming our culture of (non) innovation. But it won't happen unless three interconnected vibrant markets emerge within DoD:

* A market for Ideas

* A market for capital

* A market for talent.

The goals are to get ideas flowing, and at the same time get capital and talent flowing spontaneously to the ideas--major challenges within the DoD. In most large companies, ideas, capital, and talent are indolent. They don't move unless someone orders them to move. DoD's record of innovation (and specifically of idea generation) is poor: radical change through the venture capital model or a similar model can move us forward--but dramatically different incentives to the workforce are required.

Editor's Note: The author welcomes questions or comments on this article. Contact him at Lewismr@.navsea.navy.mil.

Lewis is currently an engineer participating in the commander's Development Program at Naval Sea Systems Command (NAVSEA), at the Washington Navy Yard, He holds a master's degree in Business Administration and graduated from Harvard Business School's "Program for Management Development." He is also a graduate of the Advanced Program Management Course (APMC 01-2), Defense Systems Management College. Fort Belvoir, Va.

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