Darden Ideas to Action Winter 2015

EXPLORING LOW-GROWTH FIRMS with Michael Schill

INSIDE The Emerging Power of the Entrepreneurial Method

The CEO Is a Good Guy. Trust Me.

Toward Adequate Housing for All

Buy Low-Growth Income Up — Firms Taxes Down

Guess What?

Your Product Is Not Perfect

IDEAS TO ACTION The title of this publication says it all. At the University of Virginia Darden School of Business, our faculty members are committed to generating new ideas that innovative business leaders can leverage to take real and transformative action in improving their organizations.

The Darden School is building on its strength of world-class educators and expanding its commitment to generating world-class ideas. The School’s faculty members have an opportunity to develop their ideas through the unique environment at Darden. Regular interaction with business leaders keeps us in touch with the “real world.” This in turn inspires our research and helps frame it to focus on topics that will have impact.

The articles in this issue illustrate the breadth of interests and expertise of Darden faculty. They also demonstrate the global reach of our research. Saras Sarasvathy’s model of entrepreneurship — effectuation — is inspiring and motivating new business owners all around the globe. The recommendation of Frank and Veronica Warnock — that improving adequate housing requires that we address a country’s housing finance system — will stimulate change.

Darden faculty members also investigate the nuances of how a business operates, as evidenced by the work spotlighted here by Michael Schill, Luann Lynch and Mary Margaret Frank. Their findings will help many executives make better decisions and improve their performance.

Business leaders everywhere would be well served to understand how the public views them. The research of Andy Wicks and Jared Harris crystalizes the uphill battle executives face in building bridges with customers and reducing the longstanding skepticism many members of the public have about our major companies.

Bringing ideas to the market is the focus of Raul Chao’s work. His insights on innovation and product launches can guide those in large companies, as well as help entrepreneurs get a leg up on success.

These stories represent just a sample of the research underway at Darden. I invite you to read more at our newly redesigned website, darden.virginia.edu, and on the Ideas to Action website, ideas.darden.virginia.edu.

S. Venkataraman Senior Associate Dean for Faculty and Research MasterCard Professor of Business Administration venkats@darden.virginia.edu

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TABLE OF CONTENTS 4 THE EMERGING POWER OF THE ENTREPRENEURIAL METHOD 8 THE CEO IS A GOOD GUY. TRUST ME. 10 TOWARD ADEQUATE HOUSING FOR ALL 12 BUY LOW-GROWTH FIRMS 16 INCOME UP — TAXES DOWN 20 GUESS WHAT? YOUR PRODUCT IS NOT PERFECT

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ENTREPRENEURSHIP

THE EMERGING POWER OF THE ENTREPRENEURIAL METHOD with Saras Sarasvathy

The entrepreneurial method, like the scientific method, will fundamentally change the world and is well on its way to doing so, says Darden Professor Saras Sarasvathy.

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“In 1620, Francis Bacon published Novum Organum, a book that explained the scientific method as the best way to understand the universe,” she says.

“With the entrepreneurial method, we are at a similar stage in history.”

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Sarasvathy’s groundbreaking research, published in a 2001 paper, launched a new way of looking at the entrepreneurial method, once thought to be unteachable. Since then, dozens of articles and books have built on her work, and in turn have reshaped the landscape of how entrepreneurship is taught, researched and practiced. In 2013, the paper she co-authored with Darden Professor Sankaran Venkataraman was one of the Top 10 most-cited papers in Entrepreneurship Theory and Practice.

“The entrepreneurial method is not as mystical, magical or nonsensical as people make it out to be,” she says.

Her research examined the method used by 30 entrepreneurial CEOs to make business decisions.

The research showed that the entrepreneurial method was used consistently by successful leaders. “My research showed that there’s this logic that is teachable,” she said. “And it’s powerful.”

She dubbed her finding “effectuation.” The term “refers to the logic — the decision-making principles — that entrepreneurs use in uncertain situations, such as starting a business, says Sarasvathy. “The alternative to effectual thinking is causal thinking, which describes decision-making that is based on predictive calculations, heuristics rooted in prediction.”

“We’re just beginning to understand that there are things you can learn systematically about entrepreneurship, but more importantly, that entrepreneurship itself is a method for us to build not just companies, but a better world,” Sarasvathy says. “It’s a method for us to unleash the human potential to create new ends and the means to attain them.”

She explains entrepreneurship in an unconventional way. “It’s not just coming up with an idea and starting a business. It’s much more than that. It’s really stitching together productive relationships between all these stakeholders and sustaining and sometimes reworking the interconnected structure until the business succeeds on its own.

And it’s even more than that.

“The entrepreneurial method can be used not only to achieve existing purposes but even to find and construct new purposes worth achieving,” she says. One classic example is the case of Muhammad Yunus, founder of Grameen Bank, who realized that he could afford to lend enough money — the princely sum of $27 — that would allow a whole village to rebuild its economy.

Later, as he expanded his loans to multiple villages, he bumped against, and overcame, the cardinal rule of banking — that loans without collateral should be unbankable. “That propelled the entire microfinancing revolution,” says Sarasvathy.

But Sarasvathy’s point is that entrepreneurship leads to surprises and that the entrepreneurial method — which includes its teachable way of thinking — can overcome hurdles, whether expected or not.

“Professor Yunus’ original purpose was not to empower illiterate women in Bangladesh by lending them money,” says Sarasvathy. “But he did — following a natural disaster — and they later returned the money and gave him gifts too. And he thought, ‘Why the heck not do this all the time?’

Now empowering poor women has become the intrinsic purpose of the venture he built.”

“I truly believe everyone should be taught the entrepreneurial method — whether you want to

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start a business or not, just as we teach science to every school student,” says Sarasvathy.

The world is now suffused with the benefits that have come from the use of the scientific method, and everyone reaps the benefit of that revolution in thinking, she says. Not everyone who learns science has to use the scientific method to better the world — just a critical mass of people, she adds. The same is true with the entrepreneurial method.

She believes that though the scientific method took several centuries to take hold, the entrepreneurial revolution will take much less time because of technology. “I think maybe 50 years. There’s already a movement in Denmark and South Africa to teach entrepreneurship in the first grade. People are pushing it earlier. The movement is definitely there.”

She says she fully expects that “in 50 years entrepreneurship will be taught in more basic ways.

We have to come up with class exercises. We have to come up with mechanisms to teach the contents.

We have to develop teaching materials.”

In the end, Sarasvathy believes the world will become a more “entrepreneurial society.” But that

doesn’t mean there will necessarily be more businesses in the world. In fact there could be fewer.

“We won’t necessarily see more ventures. But we will see people being more entrepreneurial.

Being more entrepreneurial does not necessarily mean starting more companies; it means starting better ones that endure well and create more value,” she says.

That could mean thinking in different ways about how to offer talent or help. “It could mean peer-to-peer equity investing — not only money, but time and talent. People can pitch in for staffing needs,” she says.

Meanwhile, the fervor for studying the entrepreneurial method continues unabated. There is now an effectuation society in Japan. Turkey holds an annual effectuation week — though they didn’t invite Sarasvathy, because only Turkish was being spoken at the event. The third international conference on effectuation was held in Twente, in the Netherlands in December 2014.

“We’re only 10 years into the movement and the interest is just phenomenal,” she says. “But when you think of effectuation as a toolkit for the entrepreneurial method, it makes sense.”

Saras Sarasvathy, Isidore Horween Research Professor of Business Administration at Darden, is co-author with Darden Professor Sankaran Venkataraman of “Entrepreneurship as Method: Open Questions for an Entrepreneurial Future,” published in Entrepreneurship Theory and Practice (Volume 35, Issue 1, 2011).

BEING MORE ENTREPRENEURIAL DOES NOT NECESSARILY MEAN STARTING MORE COMPANIES; IT MEANS STARTING BETTER ONES THAT ENDURE WELL AND CREATE MORE VALUE.

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BUSINESS ETHICS

The CEO is a good guy.

TRUST ME. www.ideas.darden.virginia.edu

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Here’s something that won’t surprise you. The public doesn’t trust Big Business.

Or Medium Business. Or even Little Business for that matter — at least not as institutions.

Americans are especially prone to this bias in a land where the common narrative in news stories, books and movies — even cartoon movies like Monsters Inc. — is to cast Big Business as the bad guy. The greedy CEO in Monsters Inc. was a spider.

The distrust is a lasting phenomenon. It didn’t suddenly appear after the recent Great Recession — though the crisis aggravated it — or the Occupy Wall Street movement.

Darden Professor Andy Wicks, the director of the Olsson Center for Applied Ethics at Darden, found that this enduring bad guy image worried business leaders to a great degree.

“We started back in 2006 trying to figure out what was on the minds of executives when it came to business ethics. We were shocked to find out that the number one issue by far was the public level of trust in business and executives.”

A number of Darden professors, including Wicks, Jared D. Harris, Brian Moriarty and R. Edward Freeman, helped prepare a report for managers that defined public trust, detailing why it mattered and how it impacted their businesses. They also wrote other academic articles on trust and noted that academics had explored the concept of trust in business in great depth. So why did so many academics think the subject was so important?

The reason is a practical one, says Wicks.

“There’s a lot of value, because if I can trust you and you can trust me, we can lower the transactional costs. So trust is valuable.”

The danger in being trusting, Wicks says, is you may turn out to be dealing with a cheat. “You’re going to take advantage of me and I’ve not protected myself or incentivized you to do the right thing and it falls apart,” he says.

“So the challenge is how do you create trust,” he asks. “And how do you get the right levels within an organization so you’re not trusting too much and you’re not trusting too little?”

Wicks says that trust is particularly necessary in technology companies — such as Google or Apple — though it’s also true of any company with a complex supply chain. “If you can deliver across organizational boundaries to deliver a great product — that benefits everyone — it’s highly valuable,” he says.

“There’s a lot involved here that has a tangible value. It’s not just this abstract thing. It’s incredibly important.”

But Wicks found that despite all the academic papers about trust in organizations, “almost nobody is writing about public trust in the institution of business … at least in the abstract.”

So Wicks, and fellow Darden Professors Moriarty and Harris, compiled Public Trust in Business, published in July 2014 by Cambridge University Press. The three professors edited the book, which boasts authors who are experts in business, sociology, political science and philosophy.

Harris, Moriarty and Wicks contributed chapters to the book, as well as Darden Professor Bidhan L. Parmar. The book includes contributions from renowned scholars Eric M. Uslaner, Deepak Malhotra, Robert Bies, Kirsten Martin, Michael Pirson, Karen S. Cook, Oliver Schilke, Roderick Kramer, Paul Argenti, Reinhard Bachmann, Edeltraud Hanappi-Egger, Rosalinde Klein Woolthuis, Bart Nooteboom, Gjalt de Jong, Laura Poppo and Donald J. Schepker.

The book, which combines the latest academic research with ideas for future research, explores long-term strategies for building and nurturing public trust in business. The authors address “core drivers of public trust, how to manage it effectively, the consequences of low public trust, and how best to address trust challenges and repair trust when it has been lost.”

The book evolved from the Ruffin Summit on Public Trust in Business held at Darden in 2009, at which over two dozen scholars — all of whom specialized in the area of trust — spoke to the global economic crisis, which itself was a crisis of trust.

“The book really is a compilation of academics who are in the forefront of studying trust. We thought we would start in the academic world — find out what the problems are — and write about that. We want to bring academic attention to the phenomenon,” Wicks says.

Those studies — that cross-disciplinary exchange of ideas — will hopefully result in solutions that could lead to a public trust strong enough to, finally, cast the CEO as a good guy instead of a spider.

Andrew C. Wicks, Ruffin Professor of Business Administration at Darden, is co-author with Jared D. Harris, associate professor of business administration at Darden, of “‘Public Trust’ and Trust in Particular Firm-Stakeholder Interactions,” published in Corporate Reputation Review (Volume 13, Issue 2, 2010) and with Shawn L. Berman and Thomas M. Jones of “The Structure of Optimal Trust: Moral and Strategic Implications,” published in Academy of Management Review (Volume 24, Issue 1, 1999).

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EMERGING MARKETS

TOWARD ADEQUATE HOUSING FOR ALL Darden Professors Frank Warnock and Veronica Cacdac Warnock bring their financial acumen to bear on one of the most pressing needs in the world — adequate housing. www.ideas.darden.virginia.edu

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Many developing countries suffer from “housing deficits” that the government is expected to alleviate. “A lot of countries have enormous housing backlogs — the Philippines, for example, is short 3 to 5 million units,” says Frank Warnock, an expert in financial sector development. “Many families are living in dire conditions. And the social repercussions are significant.” The common expectation is for the public sector to fill the gap, but all over the world public resources are limited, so only a small fraction of the shortfall is met.

The Warnocks focus on one bottleneck in the provision of adequate housing: a country’s housing finance system. “What you see in many countries are markets and practices that make it difficult for lenders to reach a broader set of customers,” says Veronica Warnock, an economist with a background in housing finance and development economics. Lenders might do more if they could, for example, confidently assess a potential borrower’s credit worthiness and better protect themselves against large losses due to default.

In countries with no functioning credit bureaus and vague rules regarding collateral, housing finance is marginal. “In terms of mortgage debt outstanding scaled by GDP, these countries are at less than 20 percent, compared to over 80 percent in the advanced economies,” says Veronica Warnock.

By showing that a number of factors are strongly associated with the size of housing finance systems, the Warnocks’ landmark research presents ration­ ale for policy changes that can foster a well-functioning housing finance system. Their studies prescribe basic elements that any government can put in place to encourage the provision of credit, particularly for housing. Other than mandating a proper credit information system and crafting clear rights for lenders and borrowers, governments can also help streamline the process of property registration.

The policy prescriptions appear to be straightforward — and they are — but governments still face headwinds. “Developing and maintaining a credit information system can be difficult and expensive,” Frank Warnock says. Getting the data is difficult, too. “Private companies’ incentives might work against the sharing of customers’ information,” he says. “But the system should capture sufficient credit history for most of a country’s population, something only possible when information is shared and pooled.”

“Another fundamental requirement is that governments keep inflation stable,” Veronica Warnock says. “Volatile inflation crushes debt markets and lending, including housing finance.”

Also important is a source of funding for housing finance, tricky because many such sources are

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short-term while home loans should be longer term. “Mortgage systems around the world manage the challenges, including risks, differently.”

Since 2006, the Warnocks have been presenting their work to researchers, policymakers and practitioners. They have participated in housing conferences in at least 10 countries and at meetings convening regulators and bankers in Asia and Latin America. While the Warnocks focus on housing finance, they recognize that the provision of housing is complex. “Tackling housing issues

VOLATILE INFLATION CRUSHES DEBT MARKETS AND LENDING, INCLUDING HOUSING FINANCE. means looking at land rights, urban planning and land use rules,” says Veronica Warnock. “It means reviewing other government policies that might be deterring private developers from providing affordable housing.” The issues and answers go far beyond housing finance.

In studying housing finance systems as part of complex housing issues, central to their research agenda is how governments can enable the private sector to create better housing outcomes. If there is a well-functioning housing finance system, lenders are more willing to finance home purchases for more people, improving housing affordability and enabling more people to obtain adequate housing.

Homeownership is not for everyone, but similar considerations apply in the rental market, where the question is how the private sector can be encouraged to build rental properties suitable for middle- and low-income families.

Whether through rental units or homeownership, governments and the private sector can succeed in ensuring decent housing for all. Housing finance is one piece of the puzzle.

Veronica Cacdac Warnock

Frank Warnock

Veronica Cacdac Warnock, senior lecturer and fellow at Darden’s Batten Institute for Entrepreneurship and Innovation, and Francis E. Warnock, James C. Wheat Jr. Professor of Business Administration, are authors of “Markets and Housing Finance,” published in Journal of Housing Economics (Volume 17, Issue 3, 2008), and “Developing Housing Finance Systems,” published in Property Markets and Financial Stability (2012), proceedings of a joint conference held by the Reserve Bank of Australia and the Bank for International Settlements. They co-authored with Arturo Galindo and Alessandro Rebucci “Too Small to Thrive: The Housing Finance Market,” Chapter 7 of Room for Development: Housing Markets in Latin America and the Caribbean (Inter-American Development Bank, 2012).

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FINANCE

with Michael Schill

A Surprising and Smart Investment Strategy

BUY LOWGROWTH FIRMS WINTER 2015

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Darden Professor Michael Schill set out to hunt down the answer to an odd phenomenon he noticed: Companies that were growing — with expanding assets — appeared to be a bad investment.

How could that be? Schill, an expert in corporate finance and investments, knew the observation seemed weird.

“It’s counterintuitive, but the market seemed to be enamored with firm growth to its detriment. So we began testing,” he says.

His research began with a simple question, “Do we see firms that are expanding their assets, expanding their balance sheets, doing any better or worse than those firms that are not or that are contracting? You’d expect that those expanding are the best investment and those contracting are the worst.”

“The headline finding is, that’s exactly wrong,” says Schill, “And it’s to the tune of big money.”

Schill’s research shows that, on average, from 1968 to 2008, high-growth firms that expanded their balance sheets earned about a 4 percent return annually — or just about the same as U.S. Treasury bills. Firms that expanded the least — or even contracted — earned the most — a whopping 24 percent annually. The stock market’s average yearly return is about 8 percent.

“So you’ve got this massive 20 percent spread if you bet on low-growth firms instead of highgrowth ones,” says Schill. “I’m not saying all growth is bad, but that the market systematically misprices it … the market gets too giddy about capitalizing a firm’s growth.”

Schill calls it “the absolute easiest trading strategy imaginable. Imagine starting a hedge fund and you work one day a year, on June 30. You download

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all the asset numbers for the firms in the U.S. You sort them into two baskets by comparing this year’s numbers to last year’s. Doing that over that 40-year window would get you fabulous returns. Just buy contracting firms and sell growing firms.”

Contracting firms often shrink for good reasons: because of efficiency, a reduction in inventory or just working to do more with less. Growing companies often grow for the wrong reasons.

“My view is that the market is enamored with growth. Investors systematically under-appreciate the incentive managers have to ‘empire build,’” Schill says. “Managers like to grow firms by acquisition or by green field investments — like building a new factory. The problem is, investors also like growth.”

Schill says that “the biggest variable to explain how well a manager is paid is how big the firm is. Size dominates anything else, including performance. Managers at big firms get paid more whether they do well or do poorly.”

“Certainly you get paid better if you perform better, but size dominates performance in corporations, so that creates this perverse incentive to grow your firm,” he says.

It’s well known that acquisitions are bad all around. It’s good for the target, bad for the acquirer. The reasons are usually simple. “If you’re a firm acquiring another, you’re probably paying too much or are too optimistic in how you think it will all pan out,” he says.

For example, earlier this year, Verizon grabbed

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MY VIEW IS THAT THE MARKET IS ENAMORED WITH GROWTH. INVESTORS SYSTEMATICALLY UNDER-APPRECIATE THE INCENTIVE MANAGERS HAVE TO ‘EMPIRE BUILD.’

Verizon Wireless from Vodafone for $130 billion using Verizon stock to make the buy. The German software company SAP paid $4.4 billion last year to acquire US Ariba so it could push into Cloud-based software solutions.

“Both firms appear to be trailing their respective index by a large margin post-acquisition,” says Schill. But Schill’s research shows that while growth by acquisition is systematically bad, it’s not uniquely bad. “That observation is true for any growth, including organic growth.

“Past research shows that acquisitions tend to be especially onerous if the acquiring company pays with stock or has a high valuation multiple.

But what we find in reality, is these characteristics proxy for the size of expansion. If you control for asset growth, none of the other characteristics matter. Another way of saying it is, stock deals without much asset growth don’t tend to underperform.”

A market blinded by growth will be inefficient, a fact Schill wants to emphasize. “One of our research goals is to highlight this so that hedge funds learn to trade on it. And there’s some anecdotal evidence some already do. As they do trade on it, we hope the market gets better in pricing and removes this inefficiency.”

Schill’s startling findings can help the small investor, too. “It’s a good sorting variable. When considering an investment, check to see if the balance sheet is expanding. If it is, it’s a red flag.”

Michael J. Schill, professor of business administration, is co-author with Michael J. Cooper and Huseyin Gulen of “Asset Growth and the Cross-Section of Stock Returns,” published in The Journal of Finance (Volume 63, Issue 4, 2008), and with Sandra Mortal of “The Post-Acquisition Returns of Stock Deals: Evidence of the Pervasiveness of the Asset Growth Effect,” to be published in the Journal of Financial and Quantitative Analysis (forthcoming).

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ACCOUNTING

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TAXES DOWN

INCOME U

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THE AGGRESSIVE SWEET SPOT

Two Darden professors peeked into the murky world of aggressive tax and financial reporting to discover a remarkable fact.

Firms that push the limit in reporting higher book income to shareholders also report lower taxable income to the government.

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Professors Mary Margaret Frank, an expert in tax accounting, and Luann Lynch, an expert in financial accounting, found in their pioneering research that firms that are aggressive in one type of reporting are usually aggressive in the other. These firms seek the sweet spot of reporting book income up and taxable income down.

Luann J. Lynch

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The professors said they were motivated to examine the relation between the two types of aggressive reporting by “the recent spate of accounting scandals, widespread tax shelter activity and the growing book-tax gap.” That connection was a relatively unexplored area of accounting research.

“It was our academic expertise, in combination with our knowledge of real-world issues such as the growing book-tax gap and accounting scandals, that led us to dip our toe in the water,” says Lynch.

“I’ve seen a lot of research on managers misreporting earnings, and a lot of literature on how managers make choices to engage in tax planning,” says Frank. “What you began to see at the time of Enron was that the same companies were being discussed in these separate contexts. Enron is the poster child for this because it was engaging in very

IT WAS OUR ACADEMIC EXPERTISE, IN COMBINATION WITH OUR KNOWLEDGE OF REAL-WORLD ISSUES, THAT LED US TO DIP OUR TOE IN THE WATER.

aggressive tax shelters and propping up earnings through financial manipulation.”

Lynch describes the traditional trade-off — and the inconsistencies in regulations — in simple terms. “It helps to think of firms keeping two sets of books but for all the right reasons. The financial reporting books are those books that companies use to capture their economic performance and communicate that to investors, the SEC and creditors. And then there are the tax books that companies complete to file tax returns and pay taxes.

“Those two sets of books are prepared under two different sets of guidelines,” says Lynch. “The financial books are prepared under GAAP and are regulated by the SEC. The tax books are prepared according to tax laws.”

“But there are some places where the rules for each of these sets of books aren’t connected to each other and so the managers can be aggressive on the financial books and report income that looks really good and at the same time be aggressive on the tax books and report income that isn’t so good.

They get the best of both worlds,” Lynch says. “It’s important to note that when we say aggressive, we don’t necessary mean illegal.”

“Most of the academic literature had been about the trade-off,” adds Frank. “If you want to increase book income, you have to pay more taxes, and vice versa. We examined situations in which there isn’t a trade-off. Nobody had looked at firms doing both.”

To examine those firms, the professors first had to tackle the issue of measuring tax aggressiveness — a difficult task. But the two, along with their co-author Sonja Rego, a professor at the Kelley School of Business at Indiana University, Bloom-

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ington, developed a measure “to capture tax-aggressive behavior using data analytics on publicly traded corporations,” says Frank. The professors validated their new measure of tax aggressiveness by showing it is associated with companies that have been identified using corporate tax shelters.

When they developed the measure, it isolated tax aggressive activity “as well as, or better than, the few other existing measures,” they said. Their findings were borne out by other researchers and helped inspire substantial literature on tax aggressiveness.

Using their new measure, and the standard measure in accounting literature for financial reporting aggressiveness, the professors found a “strong, positive relation between financial and tax reporting aggressiveness.”

Their research should be helpful to regulators seeking to reduce corporate malfeasance and to investors who could be fooled by aggressive financial reporting into thinking a company is doing better than it is, the professors say.

But their findings are really just a first step to answering a bigger question.

“The big question is, can you measure corporate culture — specifically, aggressive corporate culture, in which management decisions push the envelope — in acquisitions, in tax reporting, in debt leveraging, in all things business?” says Frank. “We want to explore the culture of aggressiveness in the business world.”

Lynch says that in pursuing that question “it became clear that we had to bite off a smaller piece of that larger question. And the piece we bit off was the piece we’re more familiar with from our financial and tax world, because we realized nobody

THE BIG QUESTION IS, CAN YOU MEASURE CORPORATE CULTURE— SPECIFICALLY, AGGRESSIVE CORPORATE CULTURE, IN WHICH MANAGEMENT DECISIONS PUSH THE ENVELOPE? had shown even in that limited context that there was a cultural tendency towards aggressiveness.

So if we could show there was aggression in both areas of reporting, then we might be a step closer to answering our big question.”

That research paper on the big question — in which the professors are trying to develop a measure of corporate culture using data analytics on publicly traded corporations and look beyond the accounting world — does indeed show that firms with aggressive reporting habits exhibit a propensity toward other aggressive corporate policies. The authors are hoping to see that paper in print in the near future.

Mary Margaret Frank

Mary Margaret Frank, associate professor of business administration, and Luann J. Lynch, Almand R. Coleman Professor of Business Administration, are co-authors with Sonja O. Rego of “Tax Reporting Aggressiveness and Its Relation to Aggressive Financial Reporting,” published in The Accounting Review (Volume 84, Issue 2, 2009), which received the American Taxation Association Tax Manuscript Award and Excellence in Citations Award.

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INNOVATION AND GROWTH

GUESS WHAT? YOUR PRODUCT IS NOT PERFEC with Raul Chao

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Darden Professor Raul Chao urges his entrepreneurial students — and entrepreneurs in general — to reject the traditional way of bringing a new product to market: the time-honored product launch.

Raul O. Chao, associate professor of business administration, is author of “The Ins and Outs of Open Innovation,” published in Forbes (2012), reprinted with permission on crowdsourcing.org and through Darden Business Publishing, and named one of the Top 10 articles on open innovation for 2012 by Open Innovation Community.

Chao is also co-author with Jeremy Hutchison-Krupat, assistant professor of business administration at Darden, of “Tolerance for Failure and Incentives for Collaborative Innovation,” published in Production and Operations Management (Volume 23, Issue 8, 2013).

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“I’m certainly rejecting some dogma,” he says.

“People are so used to thinking about the traditional product launch as the way to innovate.”

But the idea of the conventional launch — of creating the perfect product and waiting for just the right moment to spring it on customers with fanfare and advertising — is outdated, if not just plain wrong, says Chao.

“You don’t need to hide the product from the customer for nine months and launch it during the holiday season or at an annual product showcase. In fact, there should be no product launch,” says Chao, an expert in innovation and new product development. Instead, think of your product as perpetually imperfect, as a prototype that will evolve over time through “continuous innovation,” he says.

Chao believes entrepreneurs should toss their prototypes out to the market dogs — onto store shelves and bazaar tables — where the real world will quickly give its honest opinion about their beloved baby. Is it the equivalent of pre-cooked bacon, printers that copy and scan, or home peppercorn grinders? Or did you just come up with the equivalent of New Coke, subprime mortgages or pay toilets? If it’s the latter, it should go down the toilet. And fast.

And that’s the big bonus. Chao’s innovation strategy allows for continuous tinkering on the product with immediate feedback from the customer to learn, first, if it will sell, and then, will it

sell better with one particular improvement or another. That feedback is genuine. “Did the customer buy it after the change? Did they buy more of it or less?” he asks.

“Innovation should happen in never-ending cycles. You build a prototype, throw it out on the market, gather data from the market and then build another prototype. It’s not going to be perfect. It’s a prototype by definition. But you’re going to learn faster what the technical or market risks actually are. You learn much faster if a product or a venture is a go or a no-go,” Chao says.

To implement this philosophy, innovators must also tame the fear of failure. “Innovation is risk,” says Chao. “You need to develop a healthy tolerance for failure. I tell anyone who will listen: Let me break it to you, you’re not perfect. And your product is not perfect, either. It’s a philosophical change that is needed to make continuous innovation work. You have to accept it’s going to be an imperfect evolution. That change is not easy, particularly for Type-A personalities who are used to achieving success in almost everything they do.”

Chao has an operations background rooted in process thinking. A chemical engineer by training, he spent most of his earlier career as a systems engineer and a consultant to big businesses such as 3M, Microsoft and Lockheed Martin.

His expertise is in looking for the flaws or non-value-added activities in the sequence of events by which things get done. “Are certain

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things we do driving costs up or down? How does a process create value for customers? Is productivity increasing or decreasing? Process improvement is in my DNA,” he says.

But especially in big companies, change is difficult. “Once an organization hits a certain scale, it’s tough to continuously innovate and change processes. It requires as much cultural change as technical or process change,” says Chao. “And you have to empower everyone in the organization to make those changes.”

A few years ago, Chao turned his research focus from big companies to small companies and entrepreneurs. “I shifted on a personal and professional level to embrace the life of the entrepreneur, to understand what the individual or small company is going through in getting a new venture off the ground. I’m still focused on innovations — on the processes that drive value — but more focused on small business.”

Chao teaches a popular prototyping class at Darden, in which he estimates about half the 120 students are entrepreneurs. He teaches them that the supporting business processes must also change when the product strategy is one of continuous innovation.

“You need to gear your whole company for innovation rather than think, ‘That’s the recipe, that’s our label and everything is fixed.’ The whole system should be designed to put the product out there twice a week, not just once a year in big batches. Make small batches. Keep a low inventory on hand. Constantly innovate. Why make a bunch of stuff and put it on a shelf to sit for months on end?”

“Remember, your prototype is going to change this week, next week, the week after that and the week after that. … Regardless of what the customer might say in a focus group or survey, the way they act will tell you more. Put it out there. If they buy more of it, they like it.”

Prototyping and innovation are not just theories to Chao, who owns a business in northern Virginia that cuts and installs granite countertops. He brings the same vision of evolutionary prototyping to the businesses he owns. He also co-founded — and recently sold — a startup called Lumi Juice,

an organic fruit and vegetable juice now available throughout the mid-Atlantic region.

But Chao believes that innovation is more than just a way for companies to make money. “The soul of innovation is important to human beings.

It’s not just about organic growth and financials.

Innovation is a profoundly moral activity. You’re creating something better, something new, something that you own, not just something you get paid to do. You’re building something that will improve the world and that’s going to bring not only an economic windfall but also a psychological and moral windfall for the innovator.”

INNOVATION SHOULD HAPPEN IN NEVER-ENDING CYCLES. YOU BUILD A PROTOTYPE, THROW IT OUT ON THE MARKET, GATHER DATA FROM THE MARKET AND THEN BUILD ANOTHER PROTOTYPE. IT’S NOT GOING TO BE PERFECT. IT’S A PROTOTYPE BY DEFINITION.

WINTER 2015

Š 2015 University of Virginia Darden School of Business Ideas to Action is published by the University of Virginia Darden School of Business P.O. Box 7225 Charlottesville, Virginia 22906-7225 USA communication@darden.virginia.edu Editors Juliet Daum and Catherine Burton Art Director Susan Wormington Graphic Design Convoy Photographer Stephanie Gross Writer Carlos Santos Copy Editor Grier McCain

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