Yes, but how do you pay for it?

Last night, I was at a power networking event, and here was the question I was most asked: "Innovation – well we want it, but how do you pay for it?", Especially in a downturn, apparently. Broad consensus seemed to be that it was easy to afford innovation in the good times, but much, much harder at present.

Obviously, the bad old days where doing innovation is considered optional have not left us yet.

However, the question remains a valid one: sorting out the funding thing is indeed one of the biggest challenges a new innovation programme faces.

In my research for Innovation and the Future-proof Bank (out on August 29 – Hurrah!), I discovered there are as many funding models as there are stars in the sky. They range from elaborate internal corporate taxation schemes, to pure overhead supported by single business units. But successful innovation programmes – meaning ones which last more than 18 months – all have several common factors.

The first of these is obvious. Given scarce funding, an innovation programme must be the best available investment considering the opportunity costs of doing everything else. It is surprising how many people who do innovation fail to realise this, but why would innovation be any different to any other investment a rational business makes? It is when investments in innovation are irrational that programmes are seen to be speculative and risky. They naturally get cancelled the second the reality distortion zone generated by the sponsoring executive evaporates.

The second factor common to successful innovation programmes is they don't cost much, and it is consequently easy to justify they are the best available investment opportunity. Let's say that in a particular institution, the best available use of the money before innovation returns 49% in year 1. That's unrealistic, I know, but I use it to illustrate my point.

Let's say the innovation programme is spending a million in cash a year, and for this, they need to generate a real cash return of 1.5 million to be the best opportunity available. That's a 50% ROI, and to do it, let's imagine the innovators have made 10 100k investments. Further assuming that one fifth amount to anything, we have two investments that have to make about 750k each in the first year. Now clearly, that's not a very big ask, supposing you're screening properly. You can do that with a few changes to a volume business process in some cases.

Now let's imagine a much bigger programme now, say 10 million or so. To get to 15 million (assuming the same success rate as before), you'd need to make 100 100k investments, or a smaller number of much bigger ones. The bigger the individual investment, naturally, the more concentrated the risk. At least 80% of what an innovation programme will try is going to fail, so concentrating the risk in this way tends to be very expensive. But the fact of the matter is that very few innovation teams scale up their bandwidth at the same rate as they scale up the money.

Anyway, for argument's sake, lets imagine our innovation programme has quadrupled the number of investments it can make in a year to 40, and each is worth 250k. 20% will likely translate into value, so now we have to get 15 million out of this smaller pot of success: each must investment must return 1.87 million in year 1.

The difference between 750k and 1.87 million is very substantial: the former can likely be achieved in a single year, but unless you're lucky anything really new won't make the latter until year 2 or later. At least, not anything that starts out with a cost of 250k.

The final factor common to successful innovation programmes is they are very, very predictable in terms of making their numbers. Obviously, such programmes don't know which specific innovations are going to come out of their pipelines in advance, but they do know pretty accurately how much money they'll be making. This is a numbers game we're playing, after all, and is very little different to running a loan book. You know in advance how many loans are likely to go bad, so you can compute a return on the loan book. It is no different for an innovation portfolio, and having more investments rather than less is the best thing to spread the risk.

By making large numbers of small investments, an innovation portfolio can be as predictable as you like. You can also adjust the investments in such a way that you can hit a particular return number with a good level of precision.

Innovation programmes with all three of these success factors tend not to have to answer the funding question often. Since they're making money and at a better rate of return than other available opportunities, a rational firm will usually make a rational decision with respect to funding.

The most interesting thing that happened last night at my networking event, however, was the reaction I got when I explained all this. Apparently, lots of people still think in terms of single innovation investments. Is it any wonder that innovation is sometimes seen as optional in the bad times?

3 Responses to“Yes, but how do you pay for it?”

  1. June 3, 2009 at 9:57 am #

    When compared with the dynamics in venture capital, your points goes as saying:
    1) beat the ROI of the (internal) market to receive investment
    2) do not grow your fund, because it will get harder to make the same impressive returns
    3)show an impressive ROI on the first year
    While point 1 is a given, point 2 has not been followed by VC Funds (even if much ill has come from going too far for some of them). But most importantly point 3 has never been required for funds, which have a 10 year life horizon.
    I agree that managerial investment does not follow the sames rules as institutional investment. But net-net the question is: can you expect to pursue any meaningful innovation if you require such a short term horizon?

  2. June 3, 2009 at 10:13 am #

    Frederic,
    I don’t for a minute suggest that the the way things are is ideal. What I am suggesting, in this post, is that you have to deal with the realities as they are.
    The reality is innovation programmes *do* have short term time horizons. Notably, the time horizon is usually the length of time the sponsoring exec is in role. If you’re not making money by then, you’re out.
    OF course, this limits the *scale* of things that innovators can undertake and still live to talk about it.
    But I’d certainly aruge that building innovation capabilities takes time. You can’t just rush in and do the big transformational thing in year 1. Since that’s the case, you have no choice *but* to invest along the lines I’ve outlined.

  3. June 3, 2009 at 11:05 am #

    James, I agree with you that aspiring managers of innovation programs have to confront reality and have better follow your advice if they want to last for a couple of years.
    But I’m also defending the idea that executives should confront reality and that they are not going to get innovations that will produce any meaningful wealth for their business in 10 years from now with such short term requirements. I’m not arguing that they may have little incentives to ask for this anyway, but maybe it’s better to make it plain clear.

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