Chapter Five: The Incubation Zone

This post is the fifth in a series of posts that will eventually become a book. I am looking to improve the text by incorporating readers’ feedback before I go to print. Find out more about this project or start from the beginning.

Read the previous chapter in this series

The Incubation Zone is home to Horizon 3 investments, the ones that are not expected to reach material size for several years, sometimes considerably longer. This begs a question right from the start: Why should shareholder funds be allocated to such efforts in the first place? Why not leave them to public funding, university research, or the venture capital community?

These are totally appropriate questions, and they serve to set a high bar for established enterprises to invest in this zone. The key criteria an offering must meet to warrant Horizon 3 investment from a publicly held corporation are:

• It embodies a disruptive innovation that can drive a 10 X improvement in a performance metric of great importance to the target market. Otherwise it simply will not have sufficient impact to drive a technology adoption life cycle all the way through to scale.
• It represents a business opportunity that has the potential to scale to material size, the minimum threshold being ten percent of total enterprise revenue at the time when it reaches scale, to be achieved through a combination of organic growth and acquisitions. Otherwise it will not be able to make a stable place for itself in the performance matrix. When you incubate innovations that lack this kind of potential to scale, regardless of how cool they may be, you are just majoring in minors.
• If successful at scale, it will represent a net new line of business for the enterprise, as opposed to an adjacency to an existing line of business. Only the former will warrant a step function change in the enterprise’s overall market capitalization, and anything less than that reward does not compensate sufficiently for the venture risk involved. This point can easily get lost in the Incubation Zone because the really high-risk commitments don’t kick in until you transition to the Transformation Zone. However, since transformation is the ultimate point of the whole exercise, you must take them into account from the very start.

In sum, the Incubation Zone represents precious real estate that should not be used for corporate entertainment. It is perfectly fine to experiment with next-generation technologies and business models, just not on an officially funded basis. People can always innovate in their spare time. That’s fine. It should be part of your culture, or if you have spare cash flow, you can do this sort of thing in a lab. To get into the Incubation Zone, by contrast, fledgling businesses have to clear a much higher hurdle.   They have to make a credible claim to being the next big thing. This is the same criterion early stage venture capitalists use to qualify their prospective investments. VC success tilts heavily to the home run, and the same goes for the Incubation Zone.

Specifically, the entrance criteria for getting funded in the Incubation Zone are meant to exclude the following kinds of projects:

• Non-disruptive next generation product development in categories where the enterprise has established lines of business. These should be funded out of the Performance Zone, even when they are going to take several years to get to market.
• Ongoing platform development and corporate engineering, including participation in standards groups and the like. These should be funded out of the Productivity Zone where they will compete with other non-revenue-accountable programs for a limited pool of resources.
• Highly speculative projects that are truly futuristic. Normally these should be spun out to non-profit institutions or privately funded by venture capital. They are not a good fit for a publicly held established enterprise.

When it comes to managing businesses in the Incubation Zone, enterprises should steal a page from the venture playbook. Each funded entity is chartered to develop and bring to market a disruptive innovation, one that will create or participate in an emerging category with the potential to generate billions of dollars of sales within less than a decade. Within less than half a decade, it is the responsibility of the funded entity not just to produce a highly competitive product but also to scale itself into a viable business, roughly between one to two percent of total corporate revenues, depending on the size of the enterprise overall. At that size and state it qualifies for transitioning to the Transformation Zone, where the goal will be to scale it an order of magnitude more to surpass a tipping point threshold of roughly ten percent of total corporate revenue. To start with a business smaller than one percent normally makes no sense—the journey is just too long and the object of attention is just too small.

So rethink the Incubation Zone. It is not a lab. It is not a skunk works. It is rather a staging area for substantial businesses, a base camp within which one can scale to $100M or more in revenues (the one percent threshold for a $10B enterprise). Even at this stage businesses are still too small to manage as rows in the performance matrix, their granularity acting like grit in the gears of that bigger machine. At the same time, however, they are also way too large to manage as programs or projects. They need to have specialized sales, marketing, and professional services to compete against other start-ups on their market-facing side, and they need customized supply-chain services to design, build, and operate their next-generation disruptive offers. In short, in the Incubation Zone you are not just funding an R&D effort in engineering—you’re funding an entire company.

Managing an Incubation Zone inside an established enterprise requires innovation in its own right, leveraging some of the best practices of the venture world while still respecting your present status as a publicly held corporation. Here is a model for how to proceed:

The critical elements of this model are as follows:

• Each entity in the Incubation Zone operates as an Independent Operating Unit (IOU) with its own general manager and dedicated resources for product development, product delivery, sales, and marketing. Although it is not a full-fledged P&L, it should feel and act like a start-up company, not an R&D project.
• Each IOU is subject to a venture-funding discipline that requires meeting specific milestones in order to secure the next round, typically along the following lines:
  • Initial seed round: Validate the technology.
  • Series A round: Build a minimum viable product and validate the market.
  • Series B round: Target a beachhead market, build a viable whole product solution, and win a dominant share of new sales within that segment.
  • Series C round: Scale into adjacent markets in preparation for an exit into the Transformation Zone.
• When IOUs fail to reach a milestone, they will often warrant getting a second chance. They normally will not deserve a third one. Spaces in the incubation are too valuable to waste. When IOUs fail to win their next round of funding, they should be disassembled immediately, with any technology wins assimilated by an existing line of business where appropriate, and the staff reassigned.
• The Incubation Zone as a whole is governed by a “venture board” that determines what areas of innovation warrant investment, which business plans get funded, which IOUs get follow-on funding, what performance rewards go to which general managers, and the like. This board should consist of the CEO, the head of products, the head of engineering, and one or two other executives who have strong aptitudes for strategy and innovation management.
• The entire portfolio of IOUs in the Incubation Zone is supported by a small team of liaisons to the various shared services in the Productivity Zone. This team is specifically tasked with adjudicating the differences between the venture cadence of the IOU and the standard systems of the enterprise as a whole. Their charter is to keep the IOU team from getting bogged down or overwhelmed by corporate systems requirements while at the same time maintaining viable compliance standards. This is particularly important when the IOU is founded via an initial acquisition.
• The IOUs themselves are funded and reviewed outboard of the annual planning calendar, based on milestone target dates and not on what quarter of the fiscal year you are currently in. The overall size of the venture fund, on the other hand, is adjusted annually during the corporate planning process. Once the fund size is set, it is ring-fenced such that Horizon 3 incubation projects compete only with each other for funding, never with Horizon 1 initiatives or lines of business.
• The target exit for every IOU in the Incubation Zone is to transition to the Transformation Zone on a path to becoming a net new row in the performance matrix. That said, because that zone can process only one business transformation at a time, and because transformations take two to three years to effect, only a small fraction of the portfolio will ever achieve this outcome.
• When an IOU is not selected for this role, it must embrace one of the following remaining alternative routes to exit:
  • Assimilate into an existing line of business already established in the performance matrix, reconfiguring itself to be a sustaining innovation rather than a disruptive one. This will give it the scale needed to operate in the Performance Zone, and it will also give the established business a much-needed mid-life kicker. In other words, this can be a very good outcome indeed.
  • Scale back its deployment calendar and keep its place in the Incubation Zone, taking the extra time to be even more ready to scale when its turn comes. This is a one-time only option, with five years being a good maximum for overall time spent in this zone.
  • Spin out the business with the help of external private capital, the parent company retaining a modest equity stake and favorable IP rights. This is not a road enterprises take very often, but they should. It frees them from the distraction of a highly compelling business, one which they will drive to ruin if they don’t set it free, and it creates good will and occasionally a bonanza return for the corporation as a whole.
  • Sell the business to a company than can better capitalize on its opportunities. This in effect is a salvage operation which should be undertaken only when the assets are large enough to be material or the M&A relationship with the buyer is already well established. Otherwise it is too much of a distraction.
  • Shut the effort down.

The key point here is that space in the Incubation Zone is at a premium, and all start-ups have a “sell-by” date. The opportunity cost of not forcing these moves is to leave yourself saddled with a second-rate innovation portfolio to post up against an all-star line-up of competitors—not a promising position.  

Staffing and Compensation in the Incubation Zone

The Incubation Zone plays a role in the enterprise something like the one Dubai plays in the Middle East or Hong Kong in China. It is the exception that im-proves the rule. But this can play havoc with standard operating procedures, in particular when it comes to managing the human side of the equation.

Begin with staffing. Professionals like to report to other members of their own profession—engineers to engineers, salespeople to salespeople, and so forth. These relationships are the tracks upon which their career development train runs, both for promotion inside a company and for recruitment from outside. The Incubation Zone, however, requires all IOU resources to take direction solely from the IOU general manager. This can and should be resolved by a dual reporting relationship in which staff take direction from the GM but still report to their functional management, provided you adhere to the following practices:

• Headcount is paid for out of the IOU budget but reports into the line function, typically with a special status like “on assignment” or “overlay sales force.”
• Reviews are given by the functional manager based on extensive input from the IOU GM.
• Function management refrains from assigning any tasks to staff allocated to the IOU—their entire workload comes from the IOU GM.
• If someone underperforms in an IOU, they are reassigned back to their line function and effectively are returned to that function’s payroll.
• People so reassigned need to be reviewed carefully. They may well have great talent but are just not a good fit for the venture cadence. If so, they need to be treated well—else you are putting up a sign at the door of the Incubation Zone that says “Enter at your own risk!”

Similar to staffing, compensation in the Incubation Zone has the potential to become somewhat complicated, primarily because recruiting talent often entails competing with venture-backed start-ups. But the line to follow here is straightforward: there are no non-standard equity options involved. Such options promise the possibility of exceptional upside gains in large part to balance the very real risk of missing payroll. Enterprise IOUs don’t miss payrolls—it’s a different playing field altogether.

On the other hand IOU teams do work venture hours.   That’s what it takes to commercialize a disruptive innovation. Moreover, if they are successful, they can make an outsize contribution to the overall valuation of the company. So it does make sense to provide exceptional rewards for exceptional performance. MBOs with outsized bonuses for achieving stretch goals provide a good mechanism for this, with the Venture Board playing the role of the Compensation Committee approving the GM’s proposed awards.

Finally, there is also a precedent for spinning out IOUs very early, with a “call” right to spin them back in at a future date. This is not attractive to venture capital, but there are other forms of private equity that are willing to fund such efforts. Cisco, in particular, has been very successful with this model, using it to accelerate its entry into Storage Area Networks and Data Center Computing.

Faults and Fixes

As you can see from all of the above, this approach to funding and managing disruptive innovation is not standard corporate operating procedure. But that in effect is my point. Established enterprises have earned the reputation of not being able to innovate. Interestingly, that is not actually the case. They can and do innovate. What they cannot do is bring those innovations to scale. This is due to mismanagement in two zones, the Incubation Zone and the Transformation Zone. We will get to the latter shortly. For now, let us make sure we address the following more local mistakes:

• Separating technology development from market development. The former is done in a corporate laboratory which then seeks to accomplish the latter by transferring a prototype product to a divisional sponsor. This never works. The product is too immature and the market too undeveloped to reward the investments an established division would have to make to bring it to material size. The thing just gets lost in the shuffle, like as not eventually getting tacked onto an established product line as an accessory. If you have a corporate lab, it needs to be treated as a feeder mechanism to the Incubation Zone, not a substitute for it.
• Sharing resources between IOUs and the performance matrix. Typically enterprises try to leverage their scaled go-to-market capabilities in sales, marketing, and professional services to enable and support the scaling of a promising incubating business. Initially this can result in some serendipitous successes, but eventually the incubated entity finds itself playing second fiddle to established lines of business, especially when the latter are under significant pressure to make their number. Thus at a time when the IOU needs to be exceptionally responsive, either to execute a pivot in its strategy or to outperform a direct competitor, it loses its agility and falters.
• Burdening the incubating business with the enterprise’s obligations. Incubation is messy, and this can result in mistakes that reflect badly on a corporate brand. The temptation therefore is to require any start-up carrying “our” brand to meet expectations appropriate for our more established lines of business. That is simply too big a burden to bear. Instead, the executive team must provide air cover for its incubating efforts while at the same time making sure these IOUs are restricting their operations to appropriately early-adopting customers. One tactic to consider here is to create a sub-brand specifically dedicated to sponsoring next-generation innovations, as Red Hat has done with its Fedora brand, underscoring the message that these are experimental ventures targeted at early adopters and are not subject to the same stringent standards as mainstream product lines.
• Assigning the wrong type of leader. IOUs in the Incubation Zone must be led by entrepreneurial GMs. A good pool to draw from is ex-CEO’s from acquired companies who have successfully navigated a venture trajectory in the past. Unless you find something pretty interesting for these folks to do, they won’t stick around anyway. By contrast, long-time career executives, even those with excellent track records, are not normally willing to push the system hard enough to get things done in a disruptive context.
• Failing to shut down unqualified projects. Investing in disruptive innovation is a Darwinian exercise. It should be hard to get funded and hard to stay funded. Failure to cull the herd diffuses focus, wastes resources, and drags the entire portfolio down.
• Funding Horizon 3 investments via the annual operating plan. The annual budgeting process is organized around Horizon 1 lines of business. Disruptive innovations should never be competing with them for funding. Moreover, IOUs need to be funded based on changes in their state not on a season of the calendar. Too many underperforming ventures get to coast for too many quarters if you only review funding decisions once a year. What can and should be adjusted each year is the overall size of the venture fund itself, with the clear understanding that access to it is restricted solely to qualified Horizon 3 opportunities.
• Letting the performance matrix incubate Horizon 3 initiatives under the covers. Such efforts will never scale sufficiently to disrupt the status quo. Their sole successful outcome is next-generation innovation within the established categories served. As already noted, this is a Horizon 1 responsibility and should not be misconstrued as Horizon 3, even when its gestation period requires several years.

The key takeaway overall is that openings in the Incubation Zone should be treated as a scarce resource and not wasted on second tier opportunities or teams. Particularly when a sector is undergoing widespread disruption, the cost of missing the next wave can be catastrophic. The enterprise simply cannot afford to back anything but A players playing in A games.

Read the next chapter in this series

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Geoffrey Moore | Zone to Win Book | Geoffrey Moore Twitter | Geoffrey Moore YouTube