USING MARKET FORCES TO DRIVE

INTERNAL INNOVATION
Three key factors for getting it right

By Professor Stuart Read, Philippe Margery and Dr. Nicholas Dew - November 2008

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When it comes to driving innovation, small start-up companies have a significant edge over
their bigger counterparts. But does this have to be the case? Professor Stuart Read, Philippe
Margery and Dr Nicholas Dew share their findings on how to design an innovative “start-up”
spirit within a large corporation.

Prior research into innovation showed that, given the same research and development
investment, new ventures outperform large firms about three times in terms of number of
patents generated, number of new products and the profitability of those products.

But why is this the case? What is so different about these two types of organizations? In bigger
companies you tend to find more hierarchical structures and vertical integration in place.
Command and control. In contrast, new ventures operate more like a market internally, and
also interface (relatively) more with the external markets for capital, ideas, employees,
customers and suppliers.

So we decided to consider the opposite to a hierarchical system. What would a large firm look
like if it operated more like a market? The first thing we did was to describe the three core
elements that enable the market to function inside and outside a new venture:

1. Autonomy – providing employees the freedom to pursue what they perceive to be

interesting ideas
2. Rewards – if you create an innovation you derive some benefit, and…
3. Psychological Safety – the assurance that if you have an idea and explore it yet it fails,
you won’t be fired or penalized for it.
We then studied around 6,000 firms representing some 2.5 million employees. We found that
all three of these elements are very significantly related to innovation.

But the element that stands out, where the relationship to innovation appears to be twice as
significant, is psychological safety. It seems the most important variable to promote innovation
in the culture of an organization is the support of employees, allowing them to weather the
storm of failure. People should feel safe to try out innovative, experimental ideas without fear
of being penalized for it.

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Internal markets: mini case studies

Internal markets already exist and function within some companies. The classic example of
the use of markets inside an organization is 3M Corporation. 3M uses a very market-like
allocation system in terms of the use of employee time; employees are given one day a week
to work on whatever ideas they like.

Just look at Post-It notes. Starting with a failed technology (glue that didn’t stick), Art Fry, a
3M employee, was working on this idea in his own time and generated one of 3M’s biggest
successes.

Another example is Koch Industries, a large privately owned US corporation trading in oil and
fertilizers. It practices ‘market-based management’ which gives employees broad decision
rights and performance-related pay.

And in Silicon Valley, employees at highly successful Google can use 20% of their time to work
on whatever projects they want.

Looking again at the difference between a hierarchical organization and an internal market,
this also has an impact on decision making and the progression of ideas. The traditional
hierarchical system is like a monopoly – if you come up with a good idea and your boss doesn’t
like it, it can go no further.

In contrast, in a market you give over the responsibility to a team of people where there is
competition for ideas and there is competition for funding. More than one person who can say
‘yes’ – the idea being that the wisdom of the crowd will result in a better decision than any one
individual or expert.

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How do companies stack up today? – A spot check

We asked executives with IMD's Learning Network of major multinationals a series of

questions around our three core principles and got some interesting responses:

Autonomy. Most people said they do have the freedom to pursue their ideas, information that
may not be known further up the organization. However our sample was largely people in the
top part of organizations. The question is whether the same applies to the guy on the shop
floor? A good idea can come from anywhere in the company. In fact, people ‘on the ground’
have very local, specific and better knowledge. Innovation, such as solving a customer
problem, often comes out of this specific knowledge.

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Rewards. Nearly two-thirds of respondents said they would be better rewarded for creating
innovation outside their own organization. This suggests large firms are systematically
encouraging entrepreneurs to leave the moment they have a good idea. It is important to look
at your reward system and see if it is encouraging people to develop ideas internally or take
them elsewhere.

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Psychological Safety. Encouragingly, only 40% somewhat agreed that they would be penalized
for experimenting with a new idea and failing. However, if we asked the same question in
Silicon Valley, this figure would be closer to 0%. There it is almost a badge of honour in
technology – you have to have failed to be credible.

The real question here is how can companies institutionalize the idea of using failure as a
learning for the organization? After all not every project will result in a positive financial
outcome, but there will always be a positive knowledge outcome.

The challenge now is can you harness that knowledge, embrace the idea of an internal market
and liberate your employees to think freely? Yes? Then your company’s next great idea may be
just around the corner.

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Professor Read is Dean of Research, Development and Publishing at IMD. He is co-Director of

the Program for Executive Development and also teaches on the Advanced Strategic
Management and Strategic Marketing in Action programs.

Philipe Margery is a Research Associate at IMD.

Dr Nicholas Dew is Assistant Professor at the Graduate School of Business and Public Policy,
Naval Postgraduate School, Monterey, California.

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