Funding Innovation: Is Your Firm Doing it Wrong?
Many companies are at a loss about how to fund innovation successfully. In his new book, The Architecture of Innovation, Professor Josh Lerner starts with this advice: get the incentives right.
Here's a cautionary tale of innovation woe: Nokia has consistently outspent Apple on phone-related research and development over the past decade, especially in the years leading up to the launch of Apple's iPhone. Between 2004 and 2007, preceding the iPhone's release, Nokia spent the equivalent of $22 billion on R&D, while Apple spent a relatively paltry $2.5 billion. And yet, since that launch, Apple has far outperformed Nokia in terms of both its profit margins and its reputation for innovation. So what gives?
"This was a slow-moving train wreck."
Nokia's situation illustrates the common struggle for firms to get innovation investments right, says Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School. On one hand, firms large enough to house their own research labs too often concentrate on funding what's worked in the past rather than on the urgent needs of the future. Start-ups, on the other hand, are intensely focused on innovation but are also beholden to the impatience and boom-and-bust cycles of the venture capital industry.
In his new book, The Architecture of Innovation: The Economics of Creative Organizations, Lerner explores problems inherent in corporate R&D funding and offers up possible solutions. The key to success, he believes, may lie in adopting a hybrid model that combines aspects of both the corporate research lab and the world of VC-backed start-ups.
"When you look carefully at the nature of corporate labs and venture capital-backed firms, you see that there are both very real strengths and some serious limitations," Lerner says. "Much of the motivation for writing this book was to bridge the gap between the two models."
The history of R&D: a slow-moving train wreck
In the aftermath of World War II, government funding for scientific research increased and large corporations followed suit, with firms such as IBM, Hewlett-Packard, and Ford establishing dedicated centralized science labs that put few restrictions or deadlines on the projects within. But as the decades progressed and firms saw less and less return on investment, the value of these labs grew murkier.
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"This was a slow-moving train wreck," Lerner says. "There was a sense that the key innovations developed during the war, like radar and the atomic bomb, came from a very scientific-driven process. So corporations made enormous investments to create ivory towers where scientists would think great thoughts. At first it seemed very appealing, but as the fifties moved into the sixties and the sixties moved into the seventies, disillusion set in. In many cases, companies spent enormous sums, but without getting significant commercial returns. "
Today, in-house funding at large corporations still makes up more than half of private-sector R&D expenditures. But in reaction to the decline in results, many companies have either decentralized their research or slashed their R&D budgets, focusing instead on their core markets—and often with dreadful consequences. For instance, the book notes, Eastman Kodak's R&D outlay fell from $1.6 billion in 1992 to $859 million in 1994, as then-CEO George Fisher chose to focus on film. In part as a result of these cutbacks, the firm was late to the game in the digital imaging market. In 2012, Kodak filed for bankruptcy.
The aforementioned Nokia fixated on maintaining its leadership in the low-end phone business, a failure to anticipate the rise of smartphones that continues to dog the Finnish firm. (In June, Nokia lowered its guidance for Q2 2012, explaining in a press release that "competitive industry dynamics are negatively affecting the Smart Devices business unit to a somewhat greater extent than previously expected.")
"They decided that they were getting the most sales from the traditional phones, so they focused on that, and the opportunity came and went," Lerner says.
Meanwhile, the venture capital industry remains all about funding innovation with the understanding of risk. The book notes the historical power and success of VC, especially in information technologies. But it also details VC's shortcomings: a narrow focus on certain industries and geographies, volatile feast-or-famine funding cycles, the expectation of quick returns, and a dependence on public markets for funds.
"While the venture model works very well in certain industries in certain places at certain times, it is not a one-size-fits-all model."
"Venture capital has been a very powerful driver of innovation, and has had a lot of bang for the buck," Lerner says. "But it's necessary to understand that while the venture model works very well in certain industries in certain places at certain times, it is not a one-size-fits-all model."
Corporate venturing and internal contests
The Architecture of Innovation suggests that the solution to shortcomings with private-sector R&D funding may lie in marrying the best of the research lab and VC models. "If you combine the scale and resources of the corporate lab with some of the intensity and urgency associated with the venture capital model, you have something that can be very, very strong," Lerner says.
The book describes how, in 2008, the pharmaceutical giant GlaxoSmithKline "dramatically restructured its traditional slow-paced and bureaucratic system of R&D to emulate the relatively fast pace and entrepreneurial system of biotech companies." The firm created several specialized research teams to manage the innovation process. In order to be funded, each team is now required to pitch programs to an investment board comprising both insiders (senior GSK executives) and outsiders (including a venture capitalist and a biotech CEO). After a three-month review period, successful teams are awarded three years worth of investment funding. Because drug development and subsequent marketing can take years, it's too soon to determine the results of GSK's efforts, but preliminary indications are positive, according to Lerner.
"Glaxo has very deliberately said let's try to move to a situation where there's real accountability for what people are doing, but also enough flexibility for them to try new things when they need to," Lerner says.
Lerner also makes a case for corporate venture capital programs, in which companies fund outside efforts to develop projects that complement their goals. A poster child for this model was the iFund, a 2008 joint effort between Kleiner Perkins and Apple to invest in companies that would develop apps for the iPhone. The result: a critical mass of applications for Apple's App Store, which today boasts some 700,000 iPhone and iPad applications and 400 million customer accounts.
The book also advocates innovation incentive programs that focus not just on financial rewards but on recognition as well. To that end, Lerner recommends that firms host innovation contests, wherein individuals or teams receive prizes for solving internal problems or creating new products—noting that it's important to have a specific goal from the onset.
"I don't present these approaches as cure-alls, saying if you just run a contest or a corporate venture program everything's going to be wonderful," Lerner says. "But there's a lot of promise and potential in this tool kit."
In addition to helping executives rethink their R&D funding strategies, Lerner hopes the book will help government officials around the world craft policies and laws meant to fuel innovation.
"Policymakers are paying a lot more attention to innovation right now," Lerner says. "You see this in Washington, in Europe, and in many developing nations. Their natural instinct is to throw money at innovation. But before they do that, they need to get the environment right. Ultimately, the success and failure of innovation within these firms is probably going to be dependent not so much on more money, but on having a good environment for innovators to work in."