Innovation in Joint Ventures: Do or Die?

  

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innovations_do_or_die_water_street_partnersIN INDUSTRIES LIKE HIGH-TECH, telecommunications, and healthcare, innovation is critical to sustained competitiveness and performance. Joint ventures operating in these fast-moving markets often must compete with innovation machines like IBM, and with PE-backed startups. In our experience, the ownership structure and contractual agreements of JVs may disadvantage them in this competition.

Specifically, pursuing innovation often requires a JV to make investments, potentially including acquisitions and minority investments, in domains that are not explicitly defined within the company’s authorized scope, and to secure funding from owners, which may have other capital needs, low risk tolerance, or insufficient understanding of the market to make such investments. What are JVs to do? We talked to 16 JV CEOs to find out whether, like Ms. Rometty, they see innovation as fundamental to survival – and, if so, how they define their innovation ambition, allocate budgets toward different innovation initiatives, and establish the tools and capabilities – talent, review processes, funding mechanisms, scouting/business development – necessary for sustained success.1

In the context of a full acquisition, dealmakers would be unlikely to leave the negotiating table without all material terms being agreed and memorialized. After all, once the acquisition has occurred, the seller no longer has an interest in the purchased company and thus the buyer’s leverage post-closing to get the seller to agree to assist with transition services or other matters is seriously diminished, if it has not evaporated completely. By contrast, in a joint venture, counterparties maintain leverage after signing. Partners must still engage with each other regularly on JV startup, governance, and operations. Not surprisingly, JV partners sometimes sign a less than fully-formed deal, as partners assume they can decide unresolved issues in a favorable manner down the road.

WHAT’S OUR INNOVATION AMBITION?

In our experience, many JVs struggle with innovation from the start – and the mid-game is even tougher. To begin with, getting Board Directors of a single shareholder to clearly articulate their company’s objectives and constraints as they relate to the JV’s innovation strategy is hard enough. Aligning Board Directors from two or more shareholders is harder still, given often differing views on JV growth and evolution, and differing willingness and/or ability to invest in the JV. In fact, 69% of JV CEOs struggle to secure alignment on a long-term strategy for their venture2. Consequently, only a minority of JVs are positioned to easily articulate a clear innovation ambition.

That could be by design – only about a quarter of JVs are fully independent market entities empowered to develop and execute their own growth strategies.

The rest are designed to sit within a complex set of shareholder links, potentially including shareholder-provided services, shareholder secondees on the JV management team, shareholders serving as key customers, and shareholders as the sole source of JV funding. Equally important, shareholders may view certain JVs as “captive” – i.e., existing solely to serve their needs.

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Even so, many JV CEOs manage to claw resources to fund early-stage innovation internally, or strike partnering relationships aimed at piloting new products and processes. But many JV leaders, of even the most longstanding and successful ventures, eventually reach a precipice. Growth in the core business slows, and the innovation pipeline either is very thin or is weighted too heavily toward early stage initiatives that require meaningful investment. Do they hang on for dear life, with a “little ventured and little gained” approach built around trying to get their Board Directors to agree to relatively small-scale growth proposals? Or do they leap, painting a picture of a company that will not survive – or at least will not thrive – without pursuing real change, and the operating model redesign likely needed to unlock it?

Most management teams cling to the edge, given their hard-won appreciation for their Board Directors’ risk aversion. As one JV CEO recently told us: “My Director might get a pat on the back if we double the size of the JV by launching something new, but he’ll have the CEO yelling at him if there’s a problem with the core service that his company gets from us.” In that situation, it makes sense to stay tightly focused on incremental improvements that most benefit shareholder customers.

The JV management teams that make the leap toward successful and enduring innovation paths do so with the belief that their Board Directors will agree that innovation is an appropriate or necessary ambition for the JV. They then lead an effort to develop a shared vision for the JV’s permitted strategy, scope for growth, and available funding, and to translate this vision into principles that guide the company on its innovation journey. Caution: this is easier said than done. Most Board Directors nod their heads when asked if innovation is an appropriate ambition, and, before defining what that means to them and the shareholders they represent, they ask about the JV’s innovation pipeline and seek details about the opportunities within it. Without a clear innovation vision, including “swim lanes” for where to innovate and where not to go, plus a short list of compelling opportunities categorized by size, relation to the core business, value to the JV and shareholders, etc., management teams should not expect a soft landing.

With a shared vision for strategy, scope, and innovation, the next step is to ensure budget allocation, and the structural model employed to pursue innovation efforts, fits the vision.

HOW SHOULD WE ALLOCATE OUR INNOVATION BUDGET?

We recently asked 16 leaders of JVs outside of natural resources industries whether it is in their JV’s mandate to develop, test, and/or commercialize new products, services, business models. Most – 63% – responded “yes.” A third offered a more nuanced view, which anyone who has spent time in a joint venture can likely appreciate: “no, it’s not in our mandate but we do it anyways.” Only one participant responded “no.”

Of the 15 JVs pursuing some kind of innovation, budget allocation is linked to the JV’s mandate. For example, four of the benchmarked companies are purpose-built to innovate, and 90-100% of their budgets go toward innovation. In these cases, most of the innovation (70-100%) is in the core – though it is important to keep in mind that what is core to the JV is transformational to the shareholders. For instance, NewsCorp, NBCUniversal, and, later, Walt Disney, established Hulu to commercialize television programming in new ways (specifically, subscription-based streaming services). AES and Siemens created Fluence to lead the market in industrial energy storage, including offering storage solutions to the emergent renewables sector.

Six benchmarked companies have a mandate to innovate, though are not purpose-built for it. These JVs allocate an average of 14.5% of their budgets toward innovation activities, with 65% of innovation spending going toward core initiatives, 19% toward adjacent initiatives, and 16% toward transformational initiatives. This hews fairly closely to the “golden rule” of innovation, i.e., 70% of innovation spending on the core, 20% on adjacencies, and 10% on truly transformational initiatives.

Lastly, five benchmarked companies pursue innovation without an explicit mandate for it, and these companies allocate 4.5% of their budgets, on average, to innovation. As a group, they put 56% of their innovation spending into core initiatives, 23% into adjacent ones, and 21% into transformational ones (Exhibit 1).


Exhibit 1: Innovation Spending in Joint Ventures

innnovation_spending_in_joint_ventures

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Only three of 15 JVs indicate that they have a separate innovation fund. An innovation fund might indicate the existence of an internal innovation unit responsible for ideating and incubating new business concepts. In our experience, innovation units are fairly uncommon in JVs; most JVs embed innovation across lines of business, with development or strategy support as available.

Other “structural” options for pursuing innovation include: enabling innovation through third-party partnerships or investments; forging clear spin-out paths, in which the JV remains a test-bed for early-stage innovation initiatives that are scaled by the parents or sold to third parties; or, creating new separate legal entities to hold, develop, and/or commercialize innovative technology or intellectual property. Some JVs establish separate legal entities to house their innovation efforts, and these “NewCos” may take several different forms including a wholly-owned subsidiary of the legacy joint venture, a “sub-JV” co-owned by the legacy venture and third parties, or even a “sister JV,” in which the JV parents directly invest in NewCo, perhaps with different equity splits or the addition of third-party investors. Additionally, the new entity may be highly virtual, designed to establish corporate separateness from the legacy JV business for regulatory, liability, or other reasons, or a fully-fledged operating company with a distinct organization and budget to support and grow innovation concepts (Exhibit 2).

Pulling-forward all key terms and plans allows partners to capture the momentum and intensity of a timeline-driven negotiation. Conversely, exempting a few items from that dynamic creates the risk that those still-open issues drag on for a significant period, and potentially are never landed. Closing all items paves the way for a smoother JV start as the management team will not be distracted by ongoing negotiations and the blueprint for how the JV will work will be more complete as opposed to having large holes related to outstanding issues. Additionally, if open issues are closed out on the front end, it is likely the initial deal team who has context about the JV’s structure, scope, and challenges, will be working through these outstanding issues, as opposed to a new team that may be brought in post-signing and that lacks necessary context. 

And, of course, deals lose momentum and people lose intensity once an agreement has been executed – creating the risk that the open issues could drag on for a significant period, and potentially never be landed.
 
Perhaps most importantly, ensuring there is alignment on all material issues pre-signing significantly decreases the probability that a company will sign up to a JV that shortly down the road it wishes to exit.  Once a partner of a JV, exiting can be challenging, even with the most carefully crafted exit provisions. Companies should avoid being in a position where they need or want to exit from an established JV if one of the open issues does not shake out in their favor.

WHAT TOOLS AND CAPABILITIES DO WE NEED?

With a sharply defined vision for innovation, and an understanding of how the innovation portfolio fits the vision, JV management teams are ready to evaluate their organizational capabilities. Key questions to help assess innovation-related capabilities include:

The full version of this article elaborates on certain sections and includes  additional tools and exhibits. Click here to download the full article >>