A Metric for Measuring Innovation
Investors favor companies that "skimp" on R&D, Ashley Vance recently reported in BloombergBusinessweek. You shouldn't be shocked.
Harvard Business School professor Clayton Christensen has warned leaders about this trend for years. That trend, he says, is the tendency of public companies to be more interested in "adorning their balance sheets" than they are in pursuing innovation.
By hoarding capital, companies adorn three key metrics on their balance sheets: RONA (return on net assets), ROIC (return on invested capital), and IRR (internal rate of return). How does hoarding cash help these ratios? Well, imagine you're in charge of a public company. Every three months, investors dissect your balance sheets. You need to show them you're using your capital efficiently. If you invest millions in R&D with no discernible short-term payoff, what does an investor see? Only a reduction of cash with no measurable increase in these ratios.
Defining the Problem
And that's why the main takeaway of Bernstein Research's new report--called "Do High R&D Spenders in Tech Generate Stock Outperformance?"--shouldn't surprise you. Vance writes:
Bernstein examined technology companies since 1977 to measure R&D spending as a percentage of the company's sales. The researchers found that over 1-, 3-, 5-, and 10-year periods, the companies with the lowest spending on R&D tended to perform the best on Wall Street.
It makes sense. Investors (most of whom hold shares for less than 12 months) seek quarterly improvements in the ratios that measure capital efficiency. Leaders are judged by their ability to produce those improvements. So they hoard their capital, rather than spend it on the long-term R&D that drives real innovation.
That's the problem. What's the solution? Christensen has proposed finding an ideal metric for innovation: One that would enable (and ennoble) leaders to make the best long-term decisions for innovation without displeasing investors.
A Metric as a Solution
After reading Christensen's explanation of the problem, Alan Michael Kane, cofounder of Phunware, a developer of mobile applications whose clients include NASCAR and McDonald's, reached out with a potential solution via Twitter:
for firms w/ revenue, % revenue (w/ growth rate normalized) for products that did not exist 1,2,3,x time periods ago works
I asked Kane if he'd used this at Phunware, an Inc 500 company (circa 2013) based in Austin, Texas. "I've used that in a couple different companies," he said.
Kane's metric--which essentially measures how much new products are contributing to overall revenues, over time--is a great way to gauge your company's ability to innovate. Remember, innovation is not merely the creation of new products and services; it's the creation of new products and services that your existing or prospective customers are eager to pay for.
Kane's metric keeps the focus on revenues. Which is where it should be. As innovation guru Scott D. Anthony, a managing partner at Christensen's vaunted Innosight consultancy, has pointed out, the five essential questions you should ask (and be able to answer) about any potential innovation all swirl around the idea's revenue-generating potential:
- How will the customers obtain the product or service?
- When will they pay for it?
- Where will the customers obtain it?
- How will the product or service get to the customer?
- Is there anyone else who'll get a piece of the transaction (e.g. licensing fee, inventor royalty)?
Linking Metrics to Compensation
Of course, finding the right metric is one thing. The rub is motivating your team to perform around that particular metric.
When it comes to selling new products, that's not always easy. Sales teams sometimes err on the side of pushing established products, rather than new ones, if the established ones yield easier conversations, faster closes, and greater commissions.
The key, then, is to make sure your sales staff is putting its maximum effort behind the new products, even if doing so means a tougher path to closes and commissions.
At Phunware, Kane's sales team had a portfolio of different products, all of which were at different maturities. His solution was continually adapting the compensation structure to incentivize the sale of key new products. "You can clearly tie sales compensation to new products in the marketplace," he says.
"What you see when you do that is you get sales people talking about it. And if it isn't working, they share that info back with you."
In other words, you need to remember that innovation is a customer-driven process. You can research your idea and project how customers will pay you for it, but your sales team--on the front lines--will always provide the best reality check.