Innovation Challenges Investment Paradigms

Published in the Telegraph-Journal 20th January 2012

A critical factor responsible for the failure of many companies is that managers don’t have effective or efficient tools to help them to understand markets, analyze competitors, develop brands, select employees and develop strategy. In the absence of reliable knowledge, other tools are brought to bear to fill in the gaps. This is particularly true with firms that are seeking to finance innovation.

Raising capital is an ongoing and unending challenge for corporations. It is particularly difficult when financing innovation, in part because of the highly uncertain nature of the breakthrough or disruptive technologies that innovation may present. This is an increasingly well-known problem for start-up entrepreneurs but the investment challenge also exists for established firms.

At the outset, a fundamental problem is that proposals to create growth by exploiting potentially disruptive technologies or products cannot often be supported by hard numbers. Markets for these technologies or products can be small initially, and substantial revenues may not materialize for an extended period of time. Too often, when the financing of disruptive technology projects are pitted against incremental sustaining innovations in the battle for funding, the incremental projects receive approval while the seemingly riskier projects get delayed or die.

But an additional and more vexing problem is that managers in established corporations traditionally have used financial analysis tools and methods that can make innovation investments very difficult to justify. The most common system for green-lighting investment projects only reinforces the flaws inherent in these tools and methods.

This constellation of problems has come under the analytical microscope of Harvard University School of Business professor and author of The Innovator’s Dilemma, Clayton Christensen. His recent research asks why “so many smart, hardworking managers in well-run companies find it impossible to innovate successfully”. His team’s investigation has concluded that a misguided deployment of three financial-analysis tools is involved in what he calls “the conspiracy against successful innovation”. According to Christensen, the application of discounted cash flow and net present value to evaluate investment opportunities is “responsible for management underestimation of the real returns and benefits of investments in innovation”. In addition, his research reveals the way that fixed and sunk costs are reflected when evaluating future investments confers an unfair advantage on challengers and encumbers incumbent firms that attempt to respond to competition. Finally, his team claims that an excessive emphasis on earnings per share as the primary driver of share price and hence of shareholder value creation diverts resources away from investments whose payoff lies beyond the near term. This has resulted in an investment shortfall in business models where liquidity events are beyond the immediate horizon.

Christensen’s view is that the way these financial tools are commonly used in evaluating investment opportunity creates a systematic bias against innovation. He blames the commonly used stage-gate approval process— feasibility, development and launch—for much of the analytical distortion. His research reinforces that project teams generally know how good the financial projections need to appear in order to successfully win funding. Alternative methods, such as discovery-driven planning challenge some of the paradigms of financial analysis but they can help managers innovate with a more accurate projection of future value, and with less cost and risk. Christensen’s wider claim is that some of the tools typically used for financial analysis and decision making about investments distort the value and likelihood of the success of investments in innovation. Although he identifies business schools as laggards when teaching finance and investment, he states that there’s a better way for management teams to grow their companies. This involves paradigmatically different thinking about organization, planning, control and leadership and points to the critical importance of universities in determining the future of innovation.

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Filed under Business strategy, Innovation strategy, Suboptimality equillibrium

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