Josh Lerner: An interview by Bob Morris

Lerner, JoshJosh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, with a joint appointment in the Finance and the Entrepreneurial Management Units. He graduated from Yale College and Harvard’s Economics Department. 

Much of his research focuses on the structure and role of venture capital and private equity organizations.   He also examines policies towards innovation, and how they impact firm strategies.   He co-directs the National Bureau of Economic Research’s Productivity, Innovation, and Entrepreneurship Program and serves as co-editor of their publication, Innovation Policy and the Economy. He founded and runs the Private Capital Research Institute, a non-profit devoted to encouraging data access to and research about venture capital and private equity.

In the 1993-94 academic year, he introduced an elective course for second-year MBAs on private equity finance.  In recent years, “Venture Capital and Private Equity” has consistently been one of the largest elective courses at Harvard Business School.  He is the winner of the Swedish government’s 2010 Global Entrepreneurship Research Award and has recently been named one of the 100 most influential people in private equity over the past decade by Private Equity International magazine.

His latest book is The Architecture of Innovation: The Economics of Creative Organizations, published by Harvard Business Review Press (September 4, 2012).

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Morris: Before discussing The Architecture of Innovation, a few general questions. First, who has had the greatest influence on your professional development? How so?

Lerner: One of the great privileges over the last 20+ has been to be part of a community of scholars interested in innovation and entrepreneurship, who assemble regularly at the National Bureau of Economic Research. This group has been an invaluable source of ideas, not only about how to undertaking cutting edge studies, but what kind of big questions are the most critical.
 
Morris: Years ago, was there a turning point (if not an epiphany) that set you on the career course you continue to follow? Please explain.
 
Lerner: I had worked for a few years in Washington between college and graduate school, mostly related to questions of how policies could most effectively boost U.S. competitiveness and innovation. At a certain point, I realized that not only did we not have a very good idea as to how innovation policy should be designed, but that even the basic mechanisms of how new ideas are developed and how innovative new firms are formed was incredibly poorly understood. I headed off to Harvard eager to understand these issues, questions that I have been working on ever since!

Morris: To what extent has your formal education been invaluable to what you have accomplished in life thus far?

Lerner: Academic research is a bit of a closed shop—one needs to have a set of tools that are almost impossible to learn except through a doctoral program. The great thing about Harvard Business School is that it allows one to combine those academic skills with frequent “real world” exposure—the combination is really very powerful.
 
Morris: Of all the films that you have seen, which – in your opinion – best dramatizes important business principles? Please explain.
 
Lerner: Great question! Whatever it’s factual limitations, it’s hard not to like The Social Network for its depiction how ephemeral entrepreneurial success is—and how seemingly irrational decisions can create tremendous amounts of value. There are a lot of insights about the entrepreneurial process more generally there. More generally, we could make a long list, but it would be hard not to include The Godfather and Trading Places! 

Morris:  From which non-business book have you learned the most valuable lessons about business? Please explain.

Lerner: Another interesting issue… lots of relevant fiction for business —for instance, much of Balzac and Dickens have a lot to say about many crucial business dynamics today. Hard to pinpoint one book, though!
 
Morris: Here are several of my favorite quotations to which I ask you to respond. First, from Lao-Tzu’s Tao Te Ching:
 
“Learn from the people
Plan with the people
Begin with what they have
Build on what they know
Of the best leaders
When the task is accomplished
The people will remark
We have done it ourselves.”

Lerner: Certainly, this captures the spirit of academic research in business. A lot of what we are trying to do is “obvious” in the sense that we are trying to document and deconstruct real-world phenomena. But to make reality clearer—and hopefully, to discover some real surprises along the way—can be a major accomplishment in its own right.

Morris: Next, from Voltaire: “Cherish those who seek the truth but beware of those who find it.”

Lerner: Again, a lot of what we do as researchers in tough areas such as innovation is an ongoing conversation.  There are no final answers. Rather, each analysis builds on the ones that have come before. We like to say that we are “standing on the shoulders of giants.” And if our work is successful, it will inspire others to do follow on work as well.

Morris: And then, from Oscar Wilde: “Be yourself. Everyone else is taken.”

Lerner: Certainly, there is a lot of temptation to do what is the most profitable or acclaimed route. I am always much more of a fan if “pursuing your dream”—however, eclectic, to pursue what interests you the most.

Morris: From Albert Einstein: “We cannot solve our problems with the same thinking we used when we created them.”  

Lerner: Again, this very much captures the spirit of research.  The work that simply takes the same frameworks and applies them into different settings may be publishable, but the most exciting work is always that which takes a fresh perspective on issues.
 
Morris: In Tom Davenport’s latest book, Judgment Calls, he and co-author Brooke Manville offer “an antidote for the Great Man theory of decision making and organizational performance”: organizational judgment. That is, “the collective capacity to make good calls and wise moves when the need for them exceeds the scope of any single leader’s direct control.” What do you think?

Lerner: An alternative view of where innovations come from can be termed the “great man” theory. Breakthroughs, it is claimed, are all about visionaries, who are periodically visited by flashes of genius. Such a view has a long pedigree—think of Archimedes running naked through the streets of Syracuse after solving in the bathtub the problem of determining gold’s purity—and certainly has some truth. Indeed, many of the biographers of technology industry leaders such as Bill Gates, Steve Jobs, and Larry Ellison attribute their success to a super-human ability to spot innovations.  But this view, too, is very incomplete. Correctly predicting the future is just the beginning, not the end of the innovation process. The annals of technology are rife with individuals and firms that had a clear vision of where the future was going, yet some somehow failed to cash in on these insights. Much of the problem seems to lie in the way that the organizations were organized, that prevented them from taking advantage of these insights.Morris: Now please shift your attention to The Architecture of Innovation. When and why did you decide to write it?Lerner: There are two reasons I wrote the book.

First, the topic of innovation is vitally important today. In the aftermath of the “Great Recession,” there is an enormous appetite for growth across the world. And the need for growth leads inexorably to a hunger for innovation. There is a grim economic calculus that the U.S. and other advanced developed nations are confronting. A combination of huge unfunded liabilities and a lack of economic growth suggest a much-reduced future unless growth can be ignited. For instance, in the United States today the level of existing public expenditures and ongoing deficits arguably push the outer limits of sustainability. And the official balance sheets, if anything, understate the problem.
 
Nor do these problems show any sign of easing any time soon: the latest Congressional Budget Office estimates show the U.S. Government running a deficit until at least 2080.  Meanwhile, persistently high unemployment drains the limited resources for social services and reduces the pool of individuals paying taxes in to the system. The situation in other advanced economies is arguably even worse. Great Britain, Japan, and many nations in Continental Europe face a toxic mixture of low growth, huge debts, and substantial unemployment.
 
The easiest remedy for these problems, of course, is to simply cut costs—whether wasteful public programs or too-ambitious entitlements such as public employee pensions. But this strategy—however necessary in some cases—is likely to be far less efficacious than the average “Tea Party” enthusiast would care to believe. As the experiences of a number of nations have illustrated, too severe cutbacks may have the effect of actually perpetuating the downturns that caused the financial crisis to begin with, depressing growth and sapping consumer confidence.
 
This dilemma is not confined to the advanced industrial nations. Numerous emerging economies have come under enormous stresses, facing social unrest and outright revolution. In many cases, the unevenness of economic progress has been a key driver of discontent—even if some have benefited from growth, it has not been as substantial or as widely distributed as needed.
 
And this brings us to growth. Economic growth leads to more working people and fewer unemployed, more tax revenues, and a great easing of the pressures that nations are under. And there are essentially two ways to get such growth, at least in advanced economies that cannot simply imitate breakthroughs that have already taken place elsewhere. One is to simply add more inputs: having workers, for instance, retire at a later age or run plants later into the evening. But this strategy is essentially a game of diminishing returns: nations can only go so far in pushing people to work longer and harder.

The other alternative route is much more appealing: to get more out of the existing inputs, through a process of innovation. Such innovations can take many forms, from novel goods and services to new production processes to improved ways of organizing and managing. Since the pioneering work of Moses Abramowitz and Robert Solow in the 1950s, we have understood that technological change is critical to economic growth: innovation has not just made our lives more comfortable and longer than those of great-grandparents, but has made us richer as well. Innumerable studies have documented the strong connection between new discoveries and economic prosperity across nations and over time. This relationship is particularly strong in advanced nations—that is, countries that cannot rely on copying others or a rapidly increasing population to spur growth.

The second rationale for this book is that while there is an abundance of books linking various academic disciplines to the study of innovation—from strategy to industrial engineering to psychology—there is an important omission. The implications of organizational economics for how new ideas are developed and commercialized remains largely neglected. And organizational economics has a lot to say about how the structure of firms and incentives can lead to more innovation.

This paucity of attention reflects three facts. First, organizational economics is a relatively new field, with many of the key papers being written only in the past two decades. Second, much of what organizational economics does have to say is in little-read journals. And, of course, economists haven’t helped the cause either with our frequently arcane models and obscure writing.

Morris: You begin the book brilliantly with two M&A stories: Google’s acquisition of Motorola Mobility and Microsoft’s of Skype. In your opinion, what is the single most valuable business lesson to be learned from each?

Lerner: In August 2011, Google announced the acquisition of the bulk of Motorola.  No one had thought of the Motorola as being particularly innovative in a long time, despite their best attempts. For many years, the company had focused on filing successful patents, many of which were incremental in importance. A larger consequence of these policies—and Motorola’s approach to innovation more generally—may have been even more problematic. The company failed to pursue the innovations that led to a fundamental change in its key markets in the ensuing years. Skype, on the other hand, was acquired twice for huge sums in the 2000s, just years after being formed. Its backers’ powerful incentives and clear goals had much to do with this success.
 
Morris: How best to combine the most valuable features of the corporate research laboratory with those of the venture-backed start-up?

Lerner: Morris: Here’s one of several of your statements that caught my eye: “Correctly predicting the future is just the beginning, not the end, of the innovative process.” Please explain.

Lerner: Great ideas are surprisingly commonplace. The real key is translating these into the marketplace. To do this successfully, a lot of considerations, from financing to incentives, have to come together.

Morris: What are the [begin italics] most serious challenges [end italics] faced by those involved with a central corporate R&D laboratory? How best to overcome them?

Lerner: Corporations face two barriers when trying to get incentives right. The first is a desire to not discourage cooperation—ideally, a research laboratory will feature people from different disciplines working together. If implemented incorrectly, an incentive scheme may lead to researchers selfishly hoarding ideas, and not cooperating with each other.  While the problem is a real one, there are many ways that companies can rewards researchers working as a team.
 
A second barrier is a concern about equity: a fear that high rewards to one innovator will breed discontent if they exceed the pay packages of those around and above them. These worries are legitimate, but too often they become excuses for corporations to continue to offer flat incentives schemes with minimal added rewards for those who create great value. Moreover, in the relatively few instances where a corporation has offered uncapped rewards for important discoveries, a really valuable breakthrough has sometimes led them to abandon their inventive scheme—in at least a few instances, before paying the innovators what they promised!
 
This is a recipe for unhappy researchers and defections

Morris: What about those involved with venture-backed start-up? How best to overcome them?

Lerner: Questions increasingly surround claims that venture capital is a driver of innovation. These skeptics have been rarely been as loud as today, as the industry faces a hangover from its flurry of social media investing. Hard questions are being asked about the consequences of venture activity, whether for investors and for society as whole. In cold hard light of day—after the disappointing public market performance of once red-hot firms such as Groupon, Zynga, and Facebook, the essential constraints that limit venture capitalists’ ability to promote innovation are clear.
 
In this book, I highlight three fundamental challenges: the limited scope of venture investment, the seemingly inevitable boom-bust investment cycle, and its dependence on the mercurial public markets.  These three issues, while always somewhat of an impediment to the impact of venture funds, have become progressively more problematic in recent years. .  With some changes in industry structure, however, the industry could be considerably more successful.
 
Morris: What are the most significant advantages of decentralized innovation?

Lerner: There are several reasons why the broad scope of the central research laboratory might affect performance favorably and unfavorable.

The work of Jeremy Stein, for example, suggests the broad range of technologies considered in a diversified research lab can also contribute importantly to efficient decision-making.  When investment opportunities are poor in one technological area, he argued, managers can maintain their overall capital budget (which they value in and of itself) while still making good investments in their other sectors. By contrast, managers of narrowly focused divisional labs with poor investment opportunities have no place else to invest and, in an effort to maintain their capital budget, may end up investing in projects that are money losers. Stein’s model would suggest that when investment opportunities are poor in one sector (say life sciences), diversified central labs will be more prone than specialist firms to scale back investments in that sector and scale up their investments in more promising sectors (say, communications). 

One of the critical elements of the Stein model is that the CEO—who has no vested interest in making investments in any particular sector—gets to decide where capital is allocated. But these decision rights are not as clear-cut in large corporations. It may simply be too hard to change directions: chief technology executives sometimes refer to their task as steering as ocean liner. Another problem relates to the information that the senior managers receive. The executive suite is likely to depend critically on technologists to tell them where the greatest opportunities are. And these accounts are likely to be biased, especially given the passion and egotism that often characterizes so many innovators. For instance, the “not invented here” syndrome may lead researchers to downplay competing technologies developed by other firms: whether motivated by overconfidence or self-interest (they want their own pet project to be funded), scientists and engineers are often dismissive of ideas developed elsewhere.  The advantage of a generalist form of organization may not be as large as suggested above.
 
Morris: What about incentives and rewards for those involved with a venture-backed start-up and decentralized research more generally?

Lerner: Corporations have traditionally had very “flat” incentives for researchers.  Examples are rife of scientists and engineers who made major discoveries for their employers, yet got only token rewards. A canonical example is the $2 payment than Raytheon made to Percy Spencer as his sole compensation for discovering the microwave oven in 1945, a product that he persisted in working on despite skepticism from his superiors.  Raytheon remained a major player in the production and operation of these ovens, which were introduced first in nuclear submarines, then more generally, through the 1970s.
 
Start-ups, on the other hand, have emphasized the provision of incentives, linking long-run compensation to the success of the firm.
 
The rationale for such schemes has been supported in laboratory experiments, where it has been shown that creative exploration can co-exist with incentive compensation—as long as the incentives are designed appropriately. One fascinating illustration of this point is in a laboratory experiment run by Florian Ederer and Gustavo Manso.  In this study, the students are chosen to run electronic lemonade stands over 20 periods. There are three different groups: one which received a fixed payment regardless of the sales of lemonade, one where the payment was linked to the outcome in each of the 20 periods, and one where the compensation was only based on the profits produced in the last 10 periods. The secret of the game was that the initial location where the stand was located, while reasonably profitable, was not the ideal one. Subjects need to move dramatically away from the default selling location to find the prime spot, and hence, earn much more from their lemonade venture. Those who had long-term compensation contracts—where the pay was only dependent on where the stand ultimately ended up, not the steps along the way—were far more likely to explore adventurously, and as a result to find the right location, than either those with a fixed payment or where the payment was linked to the profits in every period.
 
An illustration of the powers of long-term incentives in the real world is from another analysis by Manso, this time with Pierre Azoulay and Joshua Graff Zivin.  The authors contrast two ways that elite biomedical scientists get funded in the U.S. Most common are grants awarded by the National Institutes of Health. These grants are relatively short-term (typically three years), and highly competitive to win and renew. Alternatively, brilliant scientists can be appointed as investigators of the Howard Hughes Medical Institute (HHMI). While they continue to work at the same university, HHMI researchers face a very different set of incentives. They are explicitly told to “change their fields” and are given the resources, time (five year renewable appointments, with a lax first-review and a two-year phase-down in case of termination), and autonomy to accomplish this. Compared with a set of equally eminent scientists with similar resources, the HHMI program appears effective in boosting the rate of discoveries, particularly of the highest-impact scientific papers. The impacts of the HHMI awards are even larger for other outcomes, such as the grooming of the next generation of cutting-edge researchers. While ultimately, the HHMI-backed scholars have strong incentives—unless their research labs deliver, the grants will ultimately be terminated—their longer-term nature of the schemes allows them to choose more productive routes.
 
While again, we must be cautious in interpretation of any individual work, taken together, the studies and other studies suggest that appropriately designed long-term incentives can boost innovation

Morris: What are the key components of the case for corporate venturing?

Lerner: Corporate venturing does fulfill three needs, at least. The first of these is the ability to respond quickly to changing circumstances. While internal research laboratories can be time consuming to build up—particularly the identification and recruitment of the right people—corporate venture programs can often identify suitable firms quickly in a promising area.
 
A second key benefit is the ability to leverage outside funds. Essentially, this gives the firm a much greater bang for the buck than if they were spending their own funds entirely. This aspect is particularly important when there is considerable technological uncertainty. In these settings, a corporate venturing program can be a cheap way of garnering critical strategic information.
 
A final advantage of corporate venturing is its ability to quickly change course. In many cases, firms—for all the talk of R&D portfolio management—find it difficult to abandon internal projects. Given these difficulties, the arms-length relationship between the corporation and the ventures it backed has real advantages. Even if the corporation is unwilling to pull the plug itself on an unpromising initiative, the presence of co-investors may force such a decision.

Corporate venturing should also allow firms to avoid many of the pitfalls affecting freestanding venture funds. Corporate venture capital funds should be able to succeed in a broader range of technologies the independent funds have, due to the skills resident in the corporate parent. The deep pockets of the parent should mean that investments are less dependent on the ebb and flow of fundraising cycles. And the fact that many of these firms may ultimately be purchased by the corporation should imply fewer distortions introduced by public markets cycles

Morris: Why have so many (if not most) efforts to achieve a middle ground between the large corporation and small start-up, as you suggest,  “go astray”?

Lerner: There are numerous challenges to such hybrids. For instance, one of the key problems with corporate venturing has to do with lack of staying power—corporations tend to be very fickle. Corporations also struggle when trying to get incentives right in these programs. A key barrier is a concern about equity: a fear that high rewards to one innovator will breed discontent if they exceed the pay packages of those around and above them. These worries are legitimate, but too often they become excuses for corporations to continue to offer flat incentives schemes with minimal added rewards for those who create great value. Moreover, in the relatively few instances where a corporation has offered uncapped rewards for important discoveries, a really valuable breakthrough has sometimes led them to abandon their inventive scheme—in at least a few instances, before paying the innovators what they promised!
 
Morris: You discuss several “lessons for venture capital” in Chapter 8. In your opinion, which one of them will be of greatest value to those who read your book? Why?
 
Lerner: Looking at venture model, it is easy to reject the all-too-frequent claims that the sector is fundamentally broken or dying. This is not to say that there are not ways to make this more fecund as a source of funding for innovation.

The most critical suggestion relates to the duration of venture partnerships. Since the early days, these funds have been structured as being eight-to-ten years in length, with provisions for one or more one-to-two year extensions. Venture capitalists typically have five years in which to invest the capital, and then are expected to use the remaining period to harvest their investments

The uniformity of these rules is puzzling. Funds differ tremendously in their investment foci: from quick-hit social media businesses to long-gestating biotechnology projects. In periods when the public markets are enthusiastic, venture capitalists may be able to exit still-immature firms that have yet to show profits and, in some cases, even revenues. But as discussed above, there has been tremendous variation in the public investors’ appetite for such firms. It is not surprising that the venture funds have increasingly focused on sectors such as software and social networking, which are characterized by fast innovation “clock speedsCertainly, within corporate research laboratories, great diversity across industries exists in terms of the typical project length. The same diversity should be seen in venture fund live

Morris:  Here’s the same question, only this time concerning lessons learned from corporate R&D: Which one of them will be of greatest value to those who read your book? Wh

Lerner: One of the key lessons for corporations from the venture sector has to do with staying power. The commitment that an institutional investor makes to a venture fund is a binding one: even if the limited partner contributes a small amount of the total capital promised at the time of closing, there is an expectation that the total amount promised will be provided. Even during the depths of the financial crisis, it was rare for investors to walk away from these commitments (a step which would have led to various sanctions, such as the forfeiture of the amount invested to date, as well as a damaged reputation). Instead, limited partners tended to sell stakes in these funds to other investors who were more liquid. In some cases, the limited partners even paid other groups to assume their commitmentLow contrast this experience with that of corporate venturing funds. Companies have been all too fickle in their commitment to corporate venturing. Often, simply the accession of a new senior officer—a replacement CEO, chief financial officer, or R&D head—has been enough to trigger the abandonment of earlier efforts: it is almost a corporate ritual to discard the pet projects of one’s predecessor!
This historical lack of commitment has, of course, real consequences. Employees are less likely to join a corporate venturing group they fund, entrepreneurs are reluctant to accept their funds, independent venture funds are hesitant to syndicate investments with these groups, and corporate funded start-ups find collaborations harder to arrange. In each case, the very real possibility that the rug will be pulled out from under the corporate venture initiative leads others to be reluctant to work alongside them.

Corporations can benefit from the process of formal commitments. Several steps can make these programs costly and time consuming to unwind: entering into legal agreements governing the fund and its economics, putting funds for these efforts into escrow, involving third parties in fund management, and incorporating the portfolio companies as independent legal entities with outside shareholders.

Morris: Let’s say that a CEO has read and then (hopefully) re-read The Architecture of Innovation and is now determined to establish an “architecture of innovation” that includes all levels and all areas of the given enterprise. Where to begin?

Lerner: I would very much recommend stepping back, taking a look at how innovations are developed and commercialized in the organization, and understanding the key organizational and structural barriers that has made innovation less effective than it might have been otherwise.

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Josh cordially invites you to check out the resources at these websites:

Harvard Business School page 

Amazon page

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