Dr. Tamir Agmon is an invited contributor to The Business Thinker. He is a Professor of Financial Economics at the School of Business, Economics and Law at Gothenburg University in Sweden.
The relations between research in business and management and the practice of management are not simple. Good research is conceptual and often is based on simplifying unrealistic assumptions. Good practice of management is concrete and is closely related to a specific situation in which the manager and the organization operate. Yet, good research contributes substantially to the practice of management just because it is not an attempt to describe business reality. Good research provides a conceptual model of reality that allows practitioners to gain a better understanding of some critical processes underlying the practice of management in a specific field.
The issue of selling innovative ideas in the market is a good example of the complex relations between research and practice in management and how managers in all levels can gain better understanding from research.
It is almost a cliche to say that the managers of today operate in a knowledge economy and that business is driven by new and innovative ideas. The communication industry, the information technology industry, the microelectronics industry and the medical industry are the most well-known industries that are driven by new and innovative ideas, but a closer look will show that even traditional industries like food, glass, and the automotive industry are affected to a great extent by new ideas pertaining to the production processes, the development of new features in existing products and to other dimensions of the business.
There is a direct connection between the ability of firms, industries and countries to adopt new and innovative ideas and their ability to generate value to their stakeholders. Some countries large like the US and small like Israel are very successful in bringing new ideas into their industries and to sell new ideas to the world other countries are not as successful. The main proposition of this article is that to be successful in generating and adopting new ideas at the corporate level there is a need of cooperation between entrepreneurs, financial intermediaries and savers. The second proposition is that managers at all levels from R&D departments to the Board of Directors can benefit by understanding the way that savings are transferred from families, households, to investments project through the flow of funds and asset allocation. Such an understanding may affect the way that the industry will manage the twin issues of innovation and buying new ideas in the market.
2. Introducing a new technology to the microelectronics industry: an example
The semiconductors industry provides a good example for the process of introducing new technology into an existing industry. At any given time the technology of manufacturing semiconductors in the industry is known as the “industry standard”. Part of the technology is common and free, other parts of the technology may be the intellectual property of specific firms that are selling the technology through licensing or any other way to the industry. At the same time many technology entrepreneurs have ideas how to change or amend the current technology to cut costs and improve output or both. Some of these ideas may be right, some may proved to be wrong or inapplicable. To better understand the process by which a new idea comes to the market consider the following simplified example; assume that three groups of technology entrepreneurs are looking for a way to improve the production process of semiconductors. The three groups work independently. They do not know of each other. All three have their own ideas but it requires time and money to test the ideas, run through alpha and beta sites and discuss the ideas with the industry. Assume that in all three cases there is a need for $5 million and three years to develop the ideas into a part of the industry standard and that the probability of success, (that is that the technology will become an industry standard) once the initial investment is made is 10%. The entrepreneurs have no money to invest. If they cannot sell their idea in the market they will not even begin with the process, will go to seek employment as engineers somewhere and their new idea will never has a chance to become a part of the industry standard.
Without entrepreneurs/innovators the likelihood of new ideas is small. The nature of industry, particularly large scale manufacturing industry is such that it does not encourage “out of the box” thinking and the likelihood of really new ideas to come from the R&D departments in the industry is small. In addition, management of large industrial companies may think that new and revolutionary ideas are too risky, they demand too much management attention, and losing money on new ideas that proved wrong is against the interest of management. If technology entrepreneurs cannot sell new innovative ideas with small probability of success everybody loses. So although the industry should be interested in innovative ideas, even if their probability of success is small many industries may find themselves continue to operate in the “old and trusted” way. In many countries this is the reason why there is not much innovation in industry if any.
In the US this issue is resolved through the venture capital (VC) funds industry. In the US and in some other countries technology entrepreneurs who have an idea can apply to a VC fund for financing. Typically this is done after completing the basic research, doing some application work, preparing a business plan and forming a skeleton of a new young innovative firm known a “start-up”. Looking at a start-up through its financial reports it is a company that has ideas on the assets’ side and entrepreneurs’ equity on the liability and net worth side. What the entrepreneurs need to do is to sell part of their idea to outsiders who will invest cash in the start up so that it can hire labor and other services to begin the process of developing the idea into cash generating asset. This is a risky proposition. Moreover, there is a build-in gap between the optimistic entrepreneurs and the pessimistic investors. The gap represents both different characters, but also a difference in information. The data shows that although only small number of ideas presented to VC funds will be financed by the funds, and only a small percentage of the ideas that the funds invest in will materialized this process generates important and revolutionary innovation in the industry.
In a world with no VC funds most innovation will come from the R&D departments of the major manufacturers and the world would have missed a substantial part of the actual innovation that took place. A good way to look at the situation is to make a distinction between two processes of innovation; one, evolutionary processes based on the work of the R&D department, and second, revolutionary process by VC funded startups that challenge existing procedures and ideas. There is an important difference between the two ways of allocating money to buy ideas; the R&D way and the VC way. Why the way that innovation is financed does affects the path of innovation? To answer these question there is a need to understand two important processes in the capital market; first, the flow of funds, and second, asset allocation.
3. The role of the capital market in the way that new ideas are developed
The flow of fund is a term in economics that describes how money gets from savings to investment. In general most savings is done by families, what economists called ‘households’, (some savings may be done by the government, but in principle the source of all savings is the household sector). By definition all the savings are going to investment. Economists denote total revenue Y and it goes either to consumption, denoted C, or to savings, denoted S. The basic relation is Y is identically equal C+S. As all the money which is not consumed is invested by definition and investment is denoted I, it follows that Y is also identically equal C+I and therefore savings S is ex post identically equal to investment I. The flow of funds is a description of how different portion of savings (sources) are going to various investments (uses). Savings are transferred to investments through a system of financial intermediaries. This is not a simple process. Most savers, (households, families) would like their savings to be low risk and liquid, many investments are risky and illiquid. There is a need in intermediation that will allow both seemingly contradictory goals to be satisfied.
This contradiction between savers and investors is resolved through a process of asset allocation by intermediaries like pension funds and other institutional investors. As the subject of this article is selling ideas in the market and innovation consider the following concrete example. CALpers is the largest pension fund in the US and as such it is a major global intermediary that transfer money from savers to investments. CALpers collects money from its members and allocate it to different uses that reflect different types of investments globally. The two relevant types of investments to the discussion of selling ideas and innovation are equities, investments by corporations and what is called Alternative Investment, a group of investments that includes primarily private equity and venture capital funds. Money invested in corporations financed R&D expenditures. Money invested in VC funds financed new start-ups. CALpers like any other large institutional investor allocates funds to all classes of assets. The following is how CALpers allocates the savings it collects among different uses:
CALpers Target Asser Allocation
Asset Class Per centage
Fixed Income 20
PE funds 10
VC funds 4
Real Estate 10
Inflation linked 5
In the ten years period 1990-2010 the annual return on the portfolio was 3.46%. However, the different components have different expected and actual return. For example, the expected rate of return on the equity component in the portfolio is at the range of 5-6% a rate that reflects medium level of risk. The expected return on the investment in VC funds is at the range of 17-25% reflecting high risk. The users of the funds are well aware of the expectations of CALpers and the other institutional investors who play an important role at the process of the flow of funds through asset allocation and their investment decisions are affected by these expectations. VC funds are expected to take high risk, corporations, (including R&D departments do not. Therefore, VC funds are likely to follow a revolutionary path in looking for new ideas and R&D departments will follow an evolutionary path.
4. VC funds are good for innovation and for the shareholders of corporations
Corporations traditionally prefer to own the innovation process either by developing new ideas in-house, or by buying outside innovators and bring them in. This reflects simple conservatism but even more than that it reflects an attempt to protect the current technology and follow an evolutionary process. Often it reflects the interest of management. The interest of the shareholders is to maximize value. They are more likely to do that by seeking new ideas that may introduce revolutionary changes that by keeping an evolutionary path of innovation. Moreover, the capital market allows shareholders to use “other people” money to finance innovation rather than to use the funds allocated by the market to the corporations themselves. Like in many other cases outsourcing generates more value, it also affects some of the existing stakeholders, in this case the internal R7D department. There is a strong argument that the dominant role of internal R&D in the pharmaceutical industry is a major reason for the lack of progress in new ethical drug and the enormous cost of what is evolutionary innovation.
Encouraging entrepreneurs/innovators to dream up and develop new and revolutionary ideas is a good thing for any industry. The ideas can relate to new products, new processes, or new uses of existing products and processes. The fact that there is a process of asset allocation in the capital market of the developed countries that turns some of the savings of people into high risk capital that is congruent with the process of selling revolutionary ideas on the market place and investing in testing their feasibility is a good thing both for the corporation as an organization and for its shareholders. A better understanding of the process of selling ideas in the market and financing the process through asset allocation will make more corporations open to an opportunity that makes everybody, innovators, savers, corporations and shareholders better off.
About the Author
Tamir Agmon is Professor of Financial Economics at the School of Business, Economics and Law at Gothenburg University in Sweden. He has been active in the academic world since receiving a PhD in Finance from the University of Chicago in 1971. He was Professor of Finance and International Business a Dean and a Chair of Finance Departments in business schools in Israel and in the US.
Professor Agmon is active in the world of venture capital and private equity as well as in the business world at large. He is currently the Managing Partner of Private Equity Group Ltd. and the Chairman of EPINAV Ltd. a US based company active in Africa.