As a VP at a fairly large company that runs a $400M revenue a year division as well as someone who has acquired startups in a number of S&P500 companies, let me tell you the truth of why big companies can’t innovate and why instead they acquire startups. Peter Drucker summed it up in one sentence “Culture eats strategy for breakfast”. I’m going to spend an entire blog post and dive a bit deeper.
It’s quite strange isn’t it, that big established companies with hundreds or even thousands of software and hardware engineers just can’t match the innovation of most of the mundane startups out there. I’m not even comparing them to successful, groundbreaking startups. Why is that?
Imagine the hotel chain Marriott, which I used very often when I traveled for business until Covid happened. Great hotels and great service. However, why were they not able to think of something similar to AirBnb before AirBnb became a thing. Now, AirBnb is a threat.
Kodak who was a leading company in photography and related products completely missed the digital camera revolution. No one rents physical DVDs at BlockBuster. Nokia, which was the Apple of its time selling phones is now a tiny fraction of once its mighty self. How did these companies screw up so badly?
How come large companies with an abundance of resources and money and even very sharp people are always behind the innovation curve? If you have worked both at startups as well as big companies like I have, the reasons will become obvious. Let me share the main reasons below.
Big Companies Are Laser Focused on What They Do Well
All of the established, profitable, and big companies today were once startups, just as you were once a cute little baby. As they became successful, they started developing processes and organizing the entire company around making their product better by adding incremental features, cheaper by optimizing the supply chain and easier to sell by perfecting the go-to market strategy including the sales pitch, the resellers, and solutions partner relationships and everything else to make it successful. Essentially the focused on perfecting and end to end process on making that product line fool proof successful.
Once a company finds a successful product and a business model, the entire management structure is assigned the goal and incentivized to exploit this model to its fullest extent possible. All the company structures, operations, processes, tools, and most importantly culture are geared towards doing what made them successful over and over again. Success is very seductive and makes you want to continue that success rather than try to do different things. Essentially “culture eats strategy for breakfast”. Any strategy that goes against the ingrained culture is doomed to fail.
They became laser-focused on safe and repeatable activities that result in steady incremental growth leaving no room for failure.
The problem is, it becomes very hard to break or do anything new outside of this business model lifecycle. Why? Because every single decision is based on the old way of doing things and protecting that mechanism.
Big Companies Expect Immediate Success and Don’t Have the Patience As VCs do
If you trace the history and timeline of startups, you will see that it takes them on average 8 to 10 years to either go public through an IPO or be acquired. By the way, majority of the startups acquired were not profitable. Also note that 90% of the startups fail.
VCs who invest tens of millions of dollars into each of these startups through multiple rounds patiently wait for 10 years to see a return on their investments. Furthermore, they invest in 15-20 companies with the assumption that only 2 or 3 will make it. Now compare the approach, investment profile, and risk tolerance that VCs exhibit to that of a large company who definitely does not have that type of a risk appetite.
Because big companies are already profitable and have successful product lines, they expect any new initiative to quickly ramp up and become successful hot sellers. But, as I just mentioned, that is very different than the VC philosophy. Therefore, there is an expectation mismatch, which results in the new initiative being pre-maturely killed and being deemed and unsuccessful.
Taking Risks is Risky in Big Companies
Because big companies expect new product ideas or initiatives to kick off and become successful quickly, unlike what happens in reality if you look at how long it takes startups to be successful, the chances of these projects being considered unsuccessful and canceled are very high. In this case, which director, Sr. director or VP would want to risk their high paying job to take on a risky project, which has a very high chance of failure? One day you were a well-paid executive, the next, you are looking for a job.
The bonus and total compensation structure do not incentivize executives to take risks. This structure instead promotes any funding to be invested in the same old product with incremental features for incremental growth. This approach is less risky and delivers higher rewards to the executives compared with trying to find a new market, new customers with a brand new and unproven solution.
Here is a real example:
Imagine a successful hardware company that sells hardware-based firewalls to large gaming companies such as Blizzard and Electronic Arts (EA). Palo Alto Networks fits the bill here, so let’s use them as an example. They probably have hardware designers (SW developers as well), they either manufacture the appliance themselves or they outsource it. Either way, there is a high cost to deliver the appliance. Adding new features or developing line cards (if it’s a chassis for empty slots) is a costly endeavor, therefore the product manager or business owner needs to make sure the ROI (return on investment) is carefully calculated by looking at the customers base, competition, market needs etc. But, nevertheless, they are going to sell the same old same old, to the same customers, using the same salespeople with almost the same sales pitch? What’s new? Well, it probably has more ports, maybe slightly faster (40G ports instead of 10G ports) and maybe it has a larger memory to store more rules to block malicious traffic.
The development might take a year to 18 months and there are a number of development status meetings to make sure the product is being developed on time as well as all the other organizations are working on their part to get ready for the launch. They forecast how many units they will sell each quarter along with the margin. And if successful, as expected, everyone will get their bonus and promotions. All good.
But Blizzard and EA are moving their applications to the public cloud and hosting all the online games on AWS, Azure, or Google Cloud (naaah, I’m kidding, Google Cloud is not that good yet. They probably use AWS). Because they are moving their applications to the public cloud they are probably going to invest less in their private data center, which means they are going to purchase fewer security appliances from Palo Alto Networks. But they do need to block malicious traffic in AWS and need some form of security devices, such as a firewall. But, Palo Alto focused on building big iron, physical security devices for data centers that Palo Alto owns. Blizzard or EA do not own AWS, hence, they need to deploy a cloud-native, scalable, on-demand type of elastic and probably pay-as-you-go software security solution. Furthermore, because Blizzard and EA have only moved a small portion of their application to AWS, they are not planning to spend much the first few years.
Palo Alto has a dilemma. The initial revenue looks very small compared to their big iron solution. Furthermore, the skillset needed to develop such a solution for AWS is very different from what they have in their engineering department. They can’t fire all the engineers and just hire engineers with different skills, because they still have to support their existing customers but also because they still need to build physical appliances for their current market. The market is just shifting slowly. What makes things more complicated is that Palo Alto is a publicly-traded company and the CEO is under pressure to show increased revenue every quarter. How else do you think your 401K is going to grow if companies don’t outpace inflation?
So, how can the CEO of Palo Alto continue the grow the company while serving both the big iron market, which brings most of the money as well as develop solutions that require significant investment for the AWS movement, which is not yet a proven market? Which Sr. VP or VP from the existing business should lead a new division for software based firewalls in AWS for Palo Alto’s enterprise customers? Which brave soul is willing to jeopardize her or his job to try to develop and sell SaaS-based solutions in a company that has optimized every single process to sell physical devices up-front. Not to mention, the salespeople get all their commission upfront when they sell big iron and retire their quota, whereas, with a SaaS solution, you are effectively spreading your revenue over a long period of time and therefore need to focus on the customer lifetime value. Yet, the salesperson wants to be paid immediately, as soon as they get a new account.
As you can see, it’s extremely risky and difficult unless the company is doing extremely well and can absorb the additional engineering cost and still grow the earning per share expectations despite the increased cost and has a CEO that is willing to break every process to support the VPs in this endeavor. This is why only very few large companies can innovate. The rest give up after trying and just acquire a startup.
Even if a startup is not profitable, as long as it can show that it has a product-market fit, has traction, and can demonstrate that it has growing revenue, it is most likely an alternative acquisition target because it has solved a number of problems for the large company. What are these problems that it has solved?
(a) It has developed a radically different product
(b) It has a way to sell it. Imagine the Palo Alto hardware example. A startup that is now selling SaaS based firewalls on AWS to enterprise companies is both a threat and an opportunity for Palo Alto.
(c) It has found a way to incentivize sales to sell this product
Let’s look at Palo Alto’s recent acquisitions (directly from Wikipedia):
- LightCyber was acquired for approximately $100 million in March 2017
- Evident.io was acquired for $300 million in cash in March 2018
- Secdo was acquired for an undisclosed sum in April 2018
- Cloud security company RedLock was acquired for $173 million in October 2018
- In February 2019, Palo Alto Networks acquired security orchestration company Demisto for $560 million
- In May 2019, Palo Alto Networks acquired container security startup Twistlock for $410 million
- In June 2019, Palo Alto Networks acquired serverless security startup PureSec for $47 million
- In September 2019, Palo Alto Networks announced its intent to acquire IoT startup Zingbox for $75 million
- In November 2019, Palo Alto Networks announced its intent to acquire machine identity-based micro-segmentation company Aporeto, Inc. for $150 million
- In March 2020, Palo Alto Networks announced its intent to acquire SD-WAN company CloudGenix, Inc. for $420 million.[70] This acquisition was completed in April 2020.
- In August 2020, Palo Alto Networks announced its intent to acquire Crypsis Group for $265 million.
There you go folks. Would love to hear your thoughts if you have any experience in this area.