How to Innovate in a Downturn

As the financial crisis continues to take its toll, a manager's natural tendency will be to hunker down, follow the status quo, and just try to survive in hopes that some day, this, too, shall pass. But that's exactly the wrong prescription.

Rahm Emanuel, President Obama's chief of staff, recently echoed Machiavelli when he said, "You never want a serious crisis to go to waste." He's correct. Now more than ever is the time for innovative managers and entrepreneurs to come up with ideas that lead to opportunities to launch new ventures.

There is considerable anecdotal evidence that crises can be catalysts for creativity. The iPod was launched within months of 9/11 and during an economic downturn. My Harvard colleague Tom Nicholas has found that while the pace of patent applications slowed during the Great Depression, some contrarians pressed ahead with innovation, including DuPont with its investments in neoprene and nylon. Hewlett-Packard and Texas Instruments were also launched during this time.

So, is this bust really a boon for innovation? The timing may seem inauspicious. The priorities in most organizations are to freeze, cut or cancel capital commitments; lower operating expenses; conserve cash; manage working capital; reduce exposure to risk; and refocus on core businesses. And even in the best of times, companies have difficulty playing two games at once. When the focus is on near-term profitability and moving toward leaner organizations, it is difficult to simultaneously invest in entrepreneurial activity with longer-term and risky payoffs. Projects that experiment with new ideas are now being shelved and funding for new ventures is being scaled back. Even Google is reining in some of its engineers' more-experimental pet projects.

That said, it is hard to argue with a basic tenet of good strategy: When other firms pull back, unmet customer needs emerge. In fact, the odds on the success of an appropriately directed new venture during a downturn may be higher in a bust than in a competitive boom. If an opportunity is articulated clearly--and is attractive enough--- what there is of capital will find a way to it. But entrepreneurs -- inside and outside of corporations -- must articulate their distinctiveness on the three fundamental decisions for any business: Where to play, how to deliver, and how to win.

Where to play: Entrepreneurs must target downturn needs such as superior value relative to existing players or provide good substitutes for the necessities that consumers have to forego. Low-cost airlines Southwest, JetBlue and Ryanair all grew during recessions, as did Charles Schwab, Home Depot, and Trader Joe's. Auto repair shops do really well in downturns while new car sales drop.

A second customer hook is affordable indulgence. As consumers pare back, they also need ways to entertain themselves and indulge in small luxuries and distractions. A large number of new media launches, from People magazine to CNN, happened during downturns, as did the growth of cosmetic companies such as Estee Lauder and Revlon. A downturn also creates new needs. Consider the effects of unemployment. In the mid-70s, John Sperling, a professor-turned-entrepreneur, realized that many working adults would need retraining. Accordingly, he founded the University of Phoenix.

How to Deliver: A common outcome of downturns is an abundance of underutilized resources that may be available at a relatively low cost. Take, for example, an expanded talent pool. Many Web 2.0 developments, including blogs and social networking, grew out of the large number of talented Web-literate workers who lost their jobs after the collapse of the Internet bubble. In addition, technologies and materials rendered superfluous by the downturn can be directed to new uses. A slowdown in semiconductor demand post-2001 made it possible for the solar industry to take off by using excess polysilicon and silicon wafers.

How to Win: Getting to the breakeven point for a new venture and then to profitable growth is crucial in any business. In a downturn, accomplishing either objective is particularly difficult. The most natural -- and common -- response is to shed employees, assets, and non-core businesses to close the gap. Often, these measures lead to the loss of valuable resources, alienation of key customers, and erosion of capabilities for the longer term. This makes the firm less competitive and probably less profitable.

This conventional response to tough times creates an opening for entrepreneurs who can meet the profitability challenge by re-examining the whole business model---a process that might involve customer acquisition or retention, or pricing innovations without adversely affecting costs or profitability. Many industry standards in these areas were set during downturns. For example, consider frequent flier programs, a standard in customer retention. Also look at Salesforce.com's innovative approach to acquiring new customers by offering software through low subscription fees and thus breaking from the industry's norm of charging a high up-front price. Both were devised during earlier slowdowns.

Another approach to winning is to lower costs without sacrificing productivity or benefits to the consumer. Selective outsourcing is a common practice today, but it was pioneered in past downturns. IBM, for example, outsourced key components in its initiative to produce the personal computer in record time during the early 1981 slump. Excesses of entrepreneurial activity can precipitate crises through excessively risky behavior, speculation, and irrational exuberance. The present crisis was triggered by such excess in the financial and real estate industries. It is only fitting for the downturn to precipitate a fresh round of entrepreneurship and innovation in a new set of industries. It would be a shame, after all, to let a serious crisis go to waste.