I’ve been asked to do a 30-minute online guest lecture for an MBA class at the California Institute of Advanced Management this Wednesday. I will discuss the relationship of innovation and corporate finance.
I invite you to watch this 30-minute presentation live at f2f.live/alexg on Aug 23, 2017 at 6:00 pm Pacific.
When I started my first business in 1994, I never thought I was in charge of corporate finance. I was simply trying to build my business the best way I knew how with the limited resources I had.
Which is exactly what corporate finance is all about.
Corporate finance says, “I’ve got these resources and those opportunities. What’s the best way to grow the business?”
It weighs the risk and return of each potential decision, and prioritizes each one.
Corporate finance decides how to structure the business and where to spend people’s time and the company’s money.
It works hard to maximize shareholder value. Which, as the only shareholder in my first company, is exactly what I was trying to do.
So it seems that corporate finance is at the heart of business success.
But something’s broken: left to itself, corporate finance doesn’t lead to success. Instead, it guarantees the death of a company.
It’s a huge irony, but MBAs are actually taught to expect this. They learn an industry “S-curve” that shows how companies and industries grow, mature, decline and die. And this prediction comes true time and time again. Think Kodak, blockbuster, borders… even a company like Microsoft has wrestled with this apparently inevitable life cycle.
Why does this happen?
Didn’t these companies have the best minds, the smartest, most experienced people? What was going on that made them unable to escape their destiny?
And, Is Corporate Decline and Death Really Inevitable?
Perhaps not. Perhaps Apple and the 3M Company can show us a different outcome.
Apple and 3M are very different from one another. Yet both enjoy remarkable long-term success that can be significantly attributed to one thing:
Apple has reinvented itself at least three times.
Apple has moved from computers to music to phones to tablets. In essence, it created four interlocking S-curves. Each S-curve timed perfectly to appear as its predecessor was reaching its peak. Each S-curve adding to Apple’s revenue and stock price. And, in a bit of brilliance, each S-curve reinforcing the other businesses, causing a 1+1+1+1=831,000,000,000 phenomenon.
3M has always had a relentless focus on innovation.
3M formally tracks the relationship between its research & development and its revenue. It knows that its future success relies on today’s R&D:
Or, to put it another way, it knows that 34% of its revenue in 2022 will come from products it will invent in the next 5 years.
These companies not only believe that innovation drives shareholder value, their stock prices prove it:
How DOES Innovation Drive Shareholder Value?
After all, innovation costs money and that reduces today’s cash flow.
In addition, innovation carries significant risks. Innovation, by definition, bets on a future that doesn’t yet exist, and in some cases can hardly be imagined.
Here are five benefits from innovation that drive shareholder value:
- Innovation creates differentiation. Differentiation allows for increased margins, fresh marketing, and a reinvigorated brand.
- Innovation extends the life of existing products. It makes them smarter, faster, lighter, stronger, more fuel efficient, etc.
- Innovation opens new opportunities and markets. A fresh approach is the best way to get a new customer’s attention and edge out a competitor – especially when they can’t match your offering.
- Innovation leverages existing customer and supplier relationships. People always prefer to deal with a trusted partner rather than somebody new.
- Innovation’s benefits are often felt beyond a single project. A culture of innovation is a rising tide whose spillover effects touch everything from HR to marketing to brand to sales.
By the way, innovation doesn’t only apply to products. It can be found everywhere: pricing, contracts, supply chains, processes, and, yes, corporate structures and financing, too.
So Why Isn’t Innovation at the Heart of Everything We’re Taught and Everything We Do?
One reason is because measuring innovation is difficult. High risk and high returns are harder to quantify.
And, even when they are quantified, the standard models we use for discounted cash flows and capital budgeting break down. They don’t appear to make sense. Rather than getting a nice, reasonable ROI like 12.4% we get zero or infinity. Both of which seem ridiculous. And, in a corporate setting, ridiculousness is often career-limiting.
Zero means the total loss of the investment. No one is going to promote THAT project.
And, when graphed, infinity is a vertical line. Which doesn’t look rational. Although… it looks kind of like a graph of the value of iPads sold in their first year (from $0 to $15 billion). Or the value of Snap the day before and the day after its $23 billion IPO.
Of course, Snap and the iPad are extreme examples. Innovation shouldn’t normally be a bet-the-farm decision. At its best, innovation is a process. It’s a series of smaller, non-lethal decisions, any one of which could fail utterly… or have a disproportionately high return.
Innovation’s value rarely comes from an individual investment, but in the aggregate of all the investment decisions.
Sure, some (or even a lot) of those decisions will turn out to be losers. But we’ll win once or twice. And those wins will generate big returns that will more than make up for the losses.
Even better, each win – and even some of the losers – creates additional value beyond an individual project. This value may be difficult to measure locally. But as it spreads across the organization, it ultimately gets measured in the stock price. And the stock price is how we measure shareholder value.
This is how 3M works. Innovation is embedded in its culture. And year after year it keeps inventing new products that power its growth. It has taken responsibility for paving its own road into a successful future.
How Can Innovation Play a Role in Corporate Finance?
As the key decision-maker that allocates precious resources, how should corporate finance include innovation in its thinking?
First, it must acknowledge the importance of innovation’s impact on shareholder value. For all of its troublesome nature, innovation is required for a firm to thrive.
Second, it must find ways to think beyond the simplistic “zero or infinity” assessment of and innovation project’s return.
One way of doing this is to consider multiple innovation projects in the aggregate.
Rather than assessing each innovation decision individually, it may be useful to consider all innovation projects as one part of a balanced portfolio of investments. Certainly, the majority of any portfolio should be safer and better-quantified investments. But wise investors reserve some portion of their portfolio to take advantage of potential home-runs.
A good example is 3M. They allocate 5% (soon to be 6%) of revenues to R&D. Not enough to jeopardize the company; but just enough to assure its future.
A good example for all of us.
Alex Glassey is a serial entrepreneur who shares his knowledge and experience to empower other business owners. Join him this fall for his exclusive BusinessPRO TV series designed for business owners only. Gain the insight, skills and confidence you need for creating a stronger, more resilient business – critical in these turbulent and uncertain times.