Many corporations exhort their employees to think outside the box without clarifying the nature of the box or its limits. Entrepreneurs and incubators focus on product innovation and try to develop a “better” product/ service/ app to get an edge. Business schools offer resources to develop the product or the app, have pitch contests to pick the best one, and then help the entrepreneurs raise money to launch the product. Consulting firms offer innovation services to help organizations “ideate” better. Universities spend vast sums promoting their technology innovations. Area economic developers promote technology innovations to build their areas.

Are they all missing the most important factor in venture success?

The biggest problem with product innovation is that most of it can be imitated and improved, their potential may be limited, or they may be highly risky because their potential is unproven. The new product has to be marketed to prove its potential. This may be acceptable for corporations since they have an existing business. All they have to do is to add the new product into their existing business model and supply chains, and use their existing marketing clout and resources to stay competitive. They don’t have to invest to create a new business around the product.

But entrepreneurs who focus on product innovations need to prove that they can implement their product innovation in order to get an edge over their existing and potential competitors, and not just be the stalking horse for someone else to imitate their product, improve the strategy, and beat them. Those expecting to get VC after developing their pitch for a “great” product/service should note that VCs only fund about 0.1 per cent of ventures (in the US) and they do it after Aha, when there is evidence of potential to dominate high-growth, emerging industries. Just saying you have a “great” product does not cut it unless you are Elon Musk and have a record of building unicorns. There are very few technologies that show this potential before they are proven in the marketplace and, as noted above, most products can be imitated.

Vinod Khosla, the co-founder of Sun Microsystems, and the founder of VC fund Khosla Ventures noted that VCs do not like to fund “science projects.” VCs rarely invest inresearch and development (Business Week, May 31, 2005).

Kleiner Perkins rejected Steve Jobs’ request for funding when Apple was a startup. Years later, when he was asked why his firm had not financed Apple as a startup, Tom Perkins, a co-founder, noted that the “key to Kleiner Perkins’s success was determining a venture’s risk, then attempting to eliminate it (Dealmaker, 11-12/ 2007)”. Perkinsdidnot see Jobs’ geniusby listening to his pitch or looking intohis eyes.

Most importantly, since most products can be imitated and improved, the key question for entrepreneurs is whether they should innovate in the product or imitate and improve in the business strategy. About 99 per cent of unicorn entrepreneurs, who built their ventures from idea to more than $1 billion in sales and valuation, grew because of their business innovation, not because of product innovation. Some got VC after proving their business strategy. Most did not.

Examples of unicorn-entrepreneurs who built business giants by pursuing business innovation include:

• Sam Walton: When the big-store concept started to take off with Kmart and Target spearheading the emerging industry in urban areas, Walton built big stores in small towns – not in urban areas.
• Steve Ells: When the organic food trend started, Ells built Chipotle by starting a chain of quick-serve restaurants to sell chemical-free chicken in stores close to universities. His customers, students who had been taught about the ills of chicken with preservatives, were his first customers.
• Steve Jobs: Imitated and improved in music downloads (iPod) and smart phone (IPhone) by legalizing music downloads and being the conduit for others’ apps.
• Michael Dell: Sold PCs like many others, but innovated in the business model by selling direct-to-the-consumer rather than using channels (htttp://www.answers.com/topic/michael-dell)
• Bill Gates: Did not develop any innovative products but bought an operating system and made it the standard by forming an alliance with IBM
• Mark Zuckerberg: Zuckerberg initially focused on universities and grabbed the best market segment that was waiting to be linked, even though others such as MySpace, were already in linking.
• Jeff Bezos: Sold books, like many others, but became a juggernaut by offering web services that became the foundation for many corporations
• Niraj Shah: Proved that furniture could be sold direct to consumers over the Internet and built Wayfair without VC.

When unicorn-entrepreneurs developed a product innovation that could be imitated, which was most of the time, they proved their potential by developing a business strategy that benefitted from the innovation. Uber is one such example. It had an innovative new app that linked the driver with a paying passenger, but it was Travis Kalanick’s successful launch that proved the concept and forced communities to make it legal to drive a “cab” without a cabbie’s license.

Chetan Patel has built SMC into a U.S. and European unicorn without any venture capital. In the heavily competitive plastics injection molding business, where he is “just” a subcontractor supplying parts to other major manufacturers, he focused on innovating in his business strategy – he speeded up the delivery of parts to his customers by changing the way molds are made. By having a huge inventory of standard mold components, he was able to complete the mold faster and save time. Time meant money for his customers, and growth for his business.

Now he is expanding his business in Cambridge (U.K.) with a new business strategy that combines product innovation developed by Cambridge scientists with full contract manufacturing to provide end-to-end solutions in the pharmaceutical drug-delivery market – proving once again that product innovation can be significantly enhanced by business innovation.

My take: A venture’s industry, stage, potential, and its competitive advantage to dominate its industry affects how VCs view its attractiveness. When the competitive advantage is in the technology, such as a cure for cancer, entrepreneurs may be able to convince VCs to invest if the technology can give the venture an edge. Then the VCs recruit experienced CEOs.

But if the competitive advantage is in the business strategy and the entrepreneur’s skill to prove the strategy and its potential, as it is in 99 per cent of unicorn-ventures, VCs are not likely to invest until after the momentum has been established. Rather than focusing on developing an “out-of-the-box” product innovation that can be easily copied, entrepreneurs and business schools should focus on business innovation skills to build a new venture – especially in an emerging industry or trend. This means you need to know how to imitate the product and improve the business strategy, launch the venture with limited capital, and take off. After take-off, the VCs will come and tell you how much they can add to your venture.

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Notes:

• This post gives the views of its author, not the position of LSE Business Review or the London School of Economics.
• Featured image by John Picton, Public domain
• Before commenting, please read our Comment Policy

Dileep Rao is clinical professor at Florida International University’s department of international business and has taught high-performance entrepreneurship, innovation, and venture financing in universities including Harvard, Stanford, University of Minnesota and INCAE (Costa Rica). He has managed five turnaround companies (four succeeded), and financed over 450 businesses and projects using equity, senior debt, subordinated debt, and leases. Professor Rao has consulted with Fortune 500 corporations, governments and development financiers. He has two engineering degrees and a Ph.D. in business administration from the University of Minnesotta.

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