Managing and Investing in Innovation

Investing in new ideas and innovative business opportunities is a process often compared to drilling for oil. Drill ten wells and you may get nine dry holes, the argument goes, but the one gusher should be enough to pay off handsomely.

It so happens that very early in my business career I was an economist for a billion-dollar independent oil company in Houston, and we frequently participated in the U.S. government’s regular auctions of offshore drilling rights in the Gulf of Mexico. Every few months the government would announce new tracts available, then auction them off by sealed bid. To evaluate each tract prior to bidding, every company’s geologists would use seismic and sonar data to map undersea rock structures and evaluate the likelihood that particular areas contained oil.

When my boss and I reviewed our company’s numbers, however, we discovered something very disturbing: Our largest and most successful bids had never generated an actual profit. None. Whenever we won a bid, in fact, we rarely found as much oil as we thought we would, and we usually didn’t earn enough money to recoup the cost of the bid and the drilling. Moreover, the bigger the potential we thought we had identified, the more money we usually lost. We found lots of oil, that wasn’t the problem. The problem was that on our most successful tracts, we had never found enough of it to recover what we had bid.

Being economists, we soon discovered a very simple mathematical reason for this. Seismic and sonar data are not exact, and no one can know with certainty how much oil is under which rock formation. Nor are geologists’ judgments uniform. Different geologists often made different judgments from the same data, so their estimates of how much oil was under any single parcel varied considerably. What this means is that whenever any company’s estimate was either much higher or much lower than everyone else’s, there was a high probability it was wrong. But at our firm, since we only bid on the “winners” we thought we had found, whenever we actually won a bid we probably did so because we over-estimated the oil potential, so we lost money. We found oil, but still lost money.

Instead of bidding high amounts only on those tracts that we estimated were the most valuable, the right bidding strategy in this kind of probabilistic situation was for us to submit intentionally low bids on a large number of different parcels. Place low-ball bets on everything, and while we will be less likely to win any particular tract, whenever we do win we're more likely to have paid a bargain price for whatever oil is actually down there. We probably wouldn’t find as much oil on any single tract, but we'd be much more likely to find enough to pay off the bid.

This is directly analogous to how businesses ought to deal with the uncertainties involved in innovation. Don’t bet your business’s future on the success of any single innovation or new technology. Instead, cover the table with smaller bets, and you’re more likely to realize a few genuine successes.

But there’s one more lesson in this story. When my boss and I took our proposed offshore oil bidding plan in to our company's Vice President of Exploration, he looked carefully though our analysis, gave us a bright and sunny smile, and then gently but firmly told us to stick to our spreadsheets. Geologists want to discover oil, he said. What a geologist puts on his resume is what oil fields he has discovered and how big they were, not how much the company had to bid for the rights.

The lesson for innovators is to align your incentives with business success, rather than project success.

Rather than “pulling out all the stops” to ensure the success of some promising innovation, for instance, why not consider squeezing its budget first, to see whether it could be even more successful, economically? Innovative projects should be managed as tightly constrained, lean startups, not because this increases their chance of success (it doesn’t), but because it radically increases their chance of profitable success.