Stories of promising but ultimately doomed attempts at technology-based diversification are all too common. The causes of failure are well known: forecast demand fails to materialize; sales and marketing efforts fall short; competitors rush in; the wrong partners are chosen; the new business proves so unlike the old that management loses its way. As a result, many companies have given up the idea of using technology-based diversification as a means of growth.

A mounting body of evidence, however, is beginning to point a way to effective high-tech diversification. Recent research into leveraged buyouts and corporate acquisitions indicates that a strong synergy with the core

business need not be a prerequisite for a successful acquisition.¹ Similarly, while most internal diversification efforts have ended in failure, some companies have thrived by building new technology-based enterprises to address markets outside their core business.

Success has come to companies of all shapes and sizes, including:

• Small companies moving out of their established markets, including aerospace companies such as Hi-Shear, which has developed a growing business in automotive braking cables and tensioners, and Acclaim Entertainment, a start-up formed by ex-aerospace engineers, which now generates more than $500 million in annual revenues in commercial entertainment markets.
• Medium-sized entrepreneurial companies, such as Science Applications International Corporation (SAIC), which has achieved rapid growth by leveraging its expertise in defense systems into civil and commercial markets, and Thermo Electron, which has built a wide range of new businesses around a set of technology capabilities that have been systematically expanded from energy to medical, environmental, and industrial process applications.
• Large traditional companies such as Corning, which has successfully entered new markets through a series of joint ventures, and Hughes Electronics, which has moved from defense electronics into commercial media markets through its new DIRECTV business.

Companies like these suggest ways of beating the high failure rate in technology-based diversification. Diverse though they are, three principles are common to all:

• Focus on value creation
• Learn from and cooperate with the market
• Manage like a venture capitalist.

Any company deciding how to pursue growth through diversification should make an objective assessment of its ability to institutionalize these principles. Though there is no single organizational model for success, some companies are clearly streets ahead of others.

Thermo Electron and SAIC, for example, can continue to pursue aggressive strategies to build new businesses because the three principles have become a natural part of their organizations thanks to the visions of their respective founders, George Hatsopolous and J.R. Beyster. Since the companies were formed in the 1960s, their leadership teams have focused on fostering entrepreneurialism. Individual business opportunities are not blocked by rigid operational or financial hurdles; instead, managers tend to "just know" which opportunities have the right profile. While no established company would readily be able to replicate their culture and characteristics, these dynamic, growing companies do provide insights into actions that can improve the chances of success in pursuing new business development.

Focus on value creation

Companies with little experience in building new businesses often harbor unrealistic expectations. A large company in aerospace, energy, or computing might well have business units with annual revenues in excess of $500 million. In such a company, senior management might expect a new business to grow within two years to $100 million in revenue with margins greater than 10 percent, and within five years to at least $500 million in revenue.

While such expectations might seem reasonable in industries accustomed to billion-dollar projects in mature businesses, they are inappropriate for a new venture. Even some of the fastest-growing technology-based enterprises of the past twenty years, such as Microsoft, Silicon Graphics, and Genentech, would have been unable to meet such ambitious expectations (Exhibit 1). It is hardly likely that a company with limited experience in new business development would be able to achieve these high levels of growth without the benefit of a major acquisition.

Managers using simple revenue and earnings targets miss the point about value creation. Consider Hughes Electronics’ DIRECTV, which began development in 1990 but does not expect to see positive returns until after 1996. Yet, when AT&T invested $137 million to acquire a 2.5 percent equity stake in the business in early 1996, its value was set at $5.5 billion. Clearly, the market’s assessment was one of substantial value creation, even though revenues remain small and earnings non-existent. As with a venture capital investment in a start-up, the key issue is not near-term revenues and earnings, but the market’s perception of value.

Once the potential for value creation has been identified, a company must determine how best to realize it. Options range from ownership and joint ventures to selling the business or licensing the technology (Exhibit 2), and may need to be reviewed at several points over the lifespan of a venture. Contrary to conventional wisdom, ownership is not usually the best path. Ownership, joint ventures, and other internal commercialization strategies are most likely to succeed with products or markets close to the core business.

A misplaced emphasis on ownership can be seen in the case of one of Britain’s leading defense companies, EMI, when it discovered the technology that was to form the basis for a revolutionary medical tool, the CAT scanner. Despite a complete lack of presence in the field, EMI decided to establish its own manufacturing facilities and conduct its own marketing, sales, and service. However, General Electric, Ohio Nuclear, and other major suppliers of medical equipment—unluckily for EMI—eventually developed the technology on their own, and were able to support it with much greater manufacturing and marketing, sales, and service resources. EMI suffered substantial losses, and eventually sold its CAT scanner business to General Electric.

Licensing can be a powerful means of capturing value, as General Electric’s own successes attest. Following its acquisition of RCA, it was able to transfer the licensing skills resident within RCA to the broader GE organi-zation, bringing in over $350 million in additional income in 1989. Ever since, it has used licensing as a means of capturing substantial value from its technical capabilities.

If a new high-tech business is to thrive, decision-making systems and management processes must be reshaped around value creation. In most companies, funding decisions for new businesses require corporate approval, and the processes used to reach such decisions are often the same as those employed in the core business. As a result, reviews may take an exceptionally long time, since risks appear steeper and investment decisions more difficult when senior management lacks the intuitive judgment that it normally applies to its core business. Indeed, the approval process may well prevent a new venture from responding quickly to an emerging market, thus inhibiting value creation.

At SAIC and Thermo Electron, decentralized decision making allows the businesses to respond rapidly to change. Operational details are not managed; instead, each business is required to meet its own agreed financial goals.

Incentive systems must also be based on value creation and reflect the needs of the new venture, not the core business. At DIRECTV, for instance, hiring top entertainment industry talent is a challenge because the entertainment and aerospace industries have totally different compensation structures. In entrepreneurial organizations, strong financial rewards provide incentives for success. Thermo Electron’s "spin-out" strategy grants managers equity stakes in their businesses when initial public offerings are made; SAIC, an employee-owned enterprise, rewards leaders of successful new ventures with additional shares in the company. In order to encourage risk-taking, the sanctions for single failures are limited in both companies.

Look to the market

A company seeking to develop a new business must marry its own technology resources with the market knowledge and capabilities of current players so that both sides have a stake in the opportunities and risks of the venture. By so doing, it can check that the potential it sees is real, ensure that essential steps in creating value are not overlooked, and help complete its business system by identifying prospective partners early.

Consider the approach used by one chemical company to build a new agribusiness venture based on a genetically engineered crop. It had developed the product but lacked key elements of the business system including brand name, knowledge of customers, and access to channels. An alliance with a seed company was formed to complete the business system and develop a pricing strategy. Traditional pricing strategies only captured a small portion of the value created, while novel strategies proposed by the technology developer met strong resistance from growers and distributors. The alliance provided a sanity check on the product concept and led to a pricing strategy, developed through an iterative process, that met the needs of growers, distributors, the seed company, and the technology developer. The result was a major success with the business valued at several times the amount prior to the alliance.

Market expertise can be acquired in a variety of ways, from hiring outside experts to establishing joint venture companies (Exhibit 3). Whichever route is chosen, the priority is to ensure that individuals or companies with strong industry credentials take a stake in the venture. One of the simplest solutions is to hire key individuals from current market players—customers, competitors, or suppliers. As well as improving a company’s ability to satisfy the demands of a new market, bringing in industry experts from established companies helps to validate a new venture and to attract other experienced hires. SAIC has started many of its new businesses in this way; indeed, one of its senior executives states: "We view our ability to recruit individuals with domain expertise in new business areas as one of our company’s core skills."

Sharing R&D is another effective approach. Customer-funded R&D has allowed Thermo Electron to develop several new businesses, sometimes with government sponsorship, as with Thermedics detectors for plastic explosives, and sometimes with funding from commercial customers, as with the development of quality control processes for soft drink containers. Such a strategy both reduces a company’s investment in development and, by demonstrating solid customer support, validates its business concept.

Joint ventures are also powerful vehicles for understanding and entering new markets. When Corning developed optical fiber technology, for example, it quickly augmented its own manufacturing, marketing, and product reach by creating joint ventures with partners such as Siemens and Plessey. Today, Corning is a leading worldwide supplier of optical fiber, cables, and supporting components.

Management must select the most appropriate path for each new venture and recognize that this path could change over time. The choice is likely to depend on the proximity of the venture to the company’s core business, the complexity of the new product or service, and the maturity of the market.

The further a new business opportunity is from the parent company’s core market, the more important it will be to draw on external knowledge and capabilities. Exhibit 4 illustrates two aerospace diversification projects, one in commercial communication networks, the other in automotive electronics. In each case, the market was new to the company; in the automotive project, many aspects of the business system were unfamiliar. The company concerned elected not to enter the market, partly because of the difficulty in completing the business system, which would have meant building complex relationships with current automotive players. Its value proposition, based primarily on technology, was simply not strong enough to justify embarking on an arduous business development path with uncertain returns.

Entering a new market is always a challenge, even when the product or service concerned is relatively simple

Entering a new market is always a challenge, even when the product or service concerned is relatively simple. Capitalizing on its military technology, Hi-Shear Industries developed a small but growing business in automotive braking cables and tensioners. In this market, automotive OEMs expected suppliers to meet very steep cost reduction targets—a concept alien to Hi-Shear’s aerospace mentality. As the company attempted to raise prices, the venture almost collapsed. Not until Hi-Shear had established deep customer relationships and hired industry expertise was it able to understand the dynamics of the market and build a successful business.

Companies with a complex product can find diversification much more difficult. Their business systems usually have more gaps that must be filled; equally important, they must develop strong relationships with customers and suppliers. In the automotive electronics industry, managing such relationships is standard practice for established players like Bosch and ITT, but virtually impossible for a new entrant that lacks access to the market capabilities of current participants. In such a case, it is critical to devise a detailed plan for developing market expertise—which will almost certainly involve setting up alliances or joint ventures—before making the decision to develop a business internally. Emerging markets that lack established players and relationships may call for a different approach. An opportunity that involves creating a new game can put entrants on an equal footing with current players. Assessing the opportunity, however, is more difficult than in mature markets, and risks are normally higher.

One approach to an emerging market is illustrated by Hughes Electronics’ DIRECTV. Hughes had long been a leader in communication satellites, but the move to managing a direct-to-home broadcast system represented a major departure from its traditional business. It had to take on the acquisition of programming content, the management of customer billing, the operation of a customer service network, and the manufacture and distribution of satellite dishes for the home. Failure in any of these areas could have caused the collapse of the entire venture.

Hiring from the entertainment industry was one of the solutions DIRECTV adopted, but a major element in its success was the early involvement of such partners as Thomson in manufacturing and distribution, DEC in billing systems, and Matrixx Marketing in customer service. Each partner had to make a substantial investment in its part of the business system, and the returns it secured depended on the success of the entire venture. Before investing, each partner researched the new business to assess its attractiveness. As one of DIRECTV’s architects admitted, "It really helped our confidence in the concept when our partners, who knew more about many aspects of the market than we did, were willing to take on part of the risk."

Manage like a venture capitalist

Most companies judge their progress—and indeed their success or failure—against a series of internally focused milestones. These typically include product development events, such as initial prototype development, or comparisons of spending levels with budget. Although these measures are helpful control mechanisms, they rarely highlight the factors that bring about large changes in a venture’s value.

A biotechnology venture producing a new diagnostic or therapeutic device might pass a series of milestones on its way to FDA approval, for example. From the company’s point of view, each step is as important as the next in achieving product commercialization. But from an external perspective, certain events—the start of trials, filing of claims, and granting of FDA approval—result in large, step-function changes in market value (Exhibit 5). The events that typically lead to the biggest jumps in market value are those that remove major uncertainties over commercial success: concerns over, say, customer acceptance, market size validation, competitive performance, or management team quality.

Viewing a company’s progress in terms of step-function changes in its market value is similar to a venture capital approach to investment. The advantage of this approach is that the parent company can identify value creation milestones in the life of its ventures. When the venture reaches one of these milestones, the parent company is in an ideal position to make critical funding and ownership decisions by selecting the most appropriate path to value capture at that point. Success or failure in reaching key value creation milestones might trigger further corporate investment, joint venture discussions, or a sale of the asset (Exhibit 6).

Monitoring a venture’s performance against value creation milestones can help both the parent and the venture’s management teams make better funding decisions. Most companies fund their ventures through annual budgeting and capital allocation cycles. But these decisions are seldom linked explicitly to the current or potential value of a venture. By tying them to periodic estimates of its market value—based on both internal assessments and market comparables—the parent and the venture can develop new perspectives on appropriate funding levels and sources.

A disguised case illustrates the role valuation can play in venture funding. Estimates of the market value of venture A range from $30 to $50 million on the basis of discounted cashflows, market comparables, and recent industry transactions. To date, the parent company has spent $10 million on developing the venture, but the venture’s management team projects that cash burn will increase to almost $10 million annually over the next two years as the commercial product launch approaches. If the next major value creation milestone will occur within 12 to 18 months, what is the most the parent company should spend on developing venture A further?

One way to approach this decision is to view the venture as a potential public entity. This IPO (initial public offering) strategy is most appealing when applied to maturing ventures. If a successful IPO of venture A could be staged, for example, it might raise $10 to $15 million—about one-third of the venture’s value. The money raised from an IPO should typically last a venture approximately 24 months before the next round of financing. From this, the parent could derive a rule of thumb in funding venture A of investing no more than $5 to $7 million annually. Otherwise, the pace of investment is likely to outstrip the pace of value creation.

Explicit discussions of value creation milestones can often lead to better ownership decisions. In this case described, funding discussions between venture and parent about funding limitations led them to consider an expanded set of options including delaying some non-critical development investments, licensing or selling non-core technology, developing R&D partnerships, and entering into non-US marketing relationships with upfront payments from partner.

When they reach these milestones, parent companies should ask three questions:

• Can we leverage the interest of other companies in this new business area? Identifying and encouraging alliances or joint ventures among interested parties can help a company strengthen its assessment of the market opportunity, complete its business system, and reduce its exposure to market risk.
• Can we realistically reach the next major milestone on our own within a tolerable level of risk? Companies often overestimate their ability to sustain success, especially in emerging markets or applications where existing market infrastructures such as sales and service eventually become critical.
• Do other companies have views of potential value that differ fundamentally from ours? Periodic assessments of market value can uncover wide variations in expectations, especially for emerging technologies and markets.

The second question can be especially important for companies used to operating independently. Take Dornier, which applied the ultrasonic shock wave technology it understood so well (through its research on material destruction for military applications) to develop the first lithotripter, a medical instrument used in the treatment of kidney stones and gallstones. Dornier’s new medical business grew rapidly, but soon reached a point where the next value creation step would entail competing against likely new products from General Electric and Siemens. Dornier’s decision to continue on an independent path prevented it from capturing value by other means such as a partnership, licensing agreement, or sale, since potential suitors had already invested in their own product development. Once the venture’s results began to decline, Dornier was locked into a failing standalone business and finally decided to disinvest after accumulating severe losses.

As the third question suggests, determining potential market value allows a parent company not only to check its own assessment but also to ascertain whether others might value its product or technology much more highly. Often, companies fail to exploit these differences in expectation through licensing, alliances, or outright sale. Those that do can capture high premiums early in the product or technology life cycle and reduce, or avoid, the risk and uncertainty of further development. Companies active in biotechnology and, more recently, on the Internet, provide a rich source of examples of how wide these differences in expectation can be.

The opportunity for technology-based companies to achieve growth by leveraging technology into new markets is real, despite the catalog of past failures. However, before a company begins to use resources that could instead be devoted to its core business, it must make certain that value creation and capture, rather than growth alone, are its primary objectives, and that it can adhere to the three principles outlined above. If it cannot, it should be content to focus on its core business and forgo technology-based diversification, with all the risks as well as opportunities that it represents.