HBR Innovation Killers

There is a lot more to say on intangibles but I need to step away from that to comment on a new Clay Christensen, Stephen Kaufman, and Willy Shih article in the January 2008 Harvard Business Review. Besides, the topic is sort of related. It is about “how financial tools destroy your capacity to do new things.” The basic idea is that financially oriented tools that may work well for guiding decisions in an existing line of business often fail when applied to new and innovative projects. The tool examples given are net present value calculations, treatment of fixed and sunk costs, and earnings per share obsession. They conclude with a discussion on how Discovery Driven Planning (DDP) -- created by Ian MacMillan and Rita McGrath as a discipline for learning your way into a new venture -- is a better approach for corporate venturing than the standard stage gate process. (For full disclosure, I worked for Mac and Rita as an undergraduate and I created and taught a case module on DDP for Wharton’s Exec Ed. And yes I was very excited to see it included in the article!)

From a big picture standpoint I think the article’s premise is entirely correct. These financial tools encourage incremental innovation over disruptive, they cause people to play numbers games to hit hurdle rates, they don’t allow for an evolving strategy, etc., etc. There is a particularly insightful section discussing how the owner/agent problem for investors and company management is now really an agent/agent problem given the role of professional investment managers. I do however disagree on some of the specifics included in the article.

Take the analysis as to how NPV is inappropriately applied in corporations considering investments in innovation. It very likely is inappropriately applied but not for the reasons provided. To get the full context you really need to read the article (hbr.org), but here is a quick summary of the argument. The authors state that NPV analysis 1) compares innovation investment cash flow forecasts against an assumed steady cash flow coming from the existing business “doing nothing” when in reality that existing cash flow is more likely to decline and 2) the impact of the terminal value estimation for investments in innovation furthers the unfair comparison.

1) IMPLIED STEADY CASH FLOW ASSUMPTION
I do not believe the authors are entirely correct in their depiction of how NPV is used to make decisions within a company. First of all, the idea that the company is making a choice between investing in innovation and “doing nothing” is false or certainly over simplified. In fact the company is definitely going to do something. The real application of NPV is to decide between a whole mess of competing projects of all kinds. Additionally, even though finance theory would dictate that a company should accept all NPV positive investments; in practice companies work with limited resources (including attention, management talent, etc.) and must choose between many competing projects -- rejecting many that (on paper) are NPV positive. Next, most large corporations divide their resources into budgets. They have budgets set aside for ongoing operations and typically have entirely separate budgets for “special projects” such as R&D, corporate ventures, etc. The rate of return they have historically seen from their ongoing operations does help set the hurdle rate for all investments but otherwise investments in specific special projects are considered separately from business as usual resource allocations. A given innovation project is much more likely to be compared on an NPV basis with another innovation project. Reducing the cash flow forecast of the existing business or even adjusting down the discount rate to acknowledge that returns from existing business will erode would not likely change the decision outcome. So I think in practice the corporate decision maker is not really falling into the “trap” the authors suggest. The person allocating the special projects budget never (directly anyhow) considers the existing business cash stream, be it steady or declining.

As a thought exercise, if a company suddenly reduced their year 3-5 cash stream estimate from the existing business, would it change how they allocate their special projects budget? It may cause them to increase the size of the special projects budget next year, effectively making more investments in innovation; however, NPV as a financial tool played no role in that change.


2) TERMINAL VALUE
Here the argument is that the right estimates for the pro forma are hard to choose, especially farther out in time. Project leaders do their best to create a 5 year projection and then “punt” to a terminal value for the out years. Terminal value takes the final projected year with an assumption of fixed future growth and turns it into an annuity. I believe the authors’ argument is that this annuity portion may underestimate the value of the innovative investment since, with innovative projects, growth rapidly accelerates after year 5. Further, the company’s existing business will be in decline by this time but, as discussed previously, the company makes an implicit assumption that it will not be declining; a more heinous assumption the farther out we go.

I believe this is the very first time I have ever heard anyone suggest that terminal values underestimate value. As the article itself mentions, terminal values often account for over half the NPV. This is an annuity that runs on forever. How much more should we possibly value it? Would not the authors’ own argument that businesses eventually decline apply to the innovative business as well? Over reliance on terminal values to make an investment case work is a much more prevalent abuse of NPV than any the authors are citing.

As always there is more to say but I better end this posting here. Again, I loved the big picture concept presented. Over and inappropriate application of quantitative financial tools will cause a company to miss the boat on innovation and lead it down a path to disruption. I only take exception on some of the specific arguments used to defend the thesis. I am not a finance person so take my analysis with a grain of salt but I think there are at least a few red flags here worth examining more closely.

Please read the article. You will be well rewarded.
http://harvardbusinessonline.hbsp.harvard.edu/hbsp/hbr/articles/article.jsp?ml_action=get-article&articleID=R0801F&ml_page=1&ml_subscriber=true

Investing in Intangible Assets

Companies (or perhaps more properly individuals within companies) are regularly faced with decisions on how best to invest their limited resources. One asset class often suspected of underinvestment is "Intangibles." Intangible assets are things like staff skills, brand, R&D, and even supplier relationships. I will divide the decisions to be made about intangibles into two buckets:

1. Investing in intangible assets
–Whether to invest in intangibles
–Deciding amongst intangible investment options
–How much to invest over what duration

2. Capitalizing on previous intangible investment
–Leverage asset internally
–Leverage asset externally
–Hold as an option


The psychology of decision making regarding intangibles probably warrants several postings but I'd like to start with some internal monologues that could go through the minds of executives making decisions of type #1 that would lead to underinvestment:


Investment and return are significantly separated in time

* I have a large implied discount rate (which may be significantly greater than the one I have for tangible investments)

* My micro incentives are misaligned (I wont still be in this job when the return comes)

Complexity of system interactions that eventually lead to return

* The number of steps between investment and return makes this investment too confusing for me to be comfortable.

* Complexity means it will be hard for others to give me proper credit for the returns when they do come (Will they see I caused this positive return or will it be attributed to someone else?). On the contrary – it may be more difficult to assign losses.

Accounting

* Because it is so hard to attribute gains, my spending on intangibles may be accounted for and seen by others simply as a cost versus an investment. No asset goes on the books to reflect my investment.

Control

* I don’t have the same level of control over intangible assets which makes me nervous. I like to feel in control. I have more trouble becoming a gate keeper to my intangible asset which is a key source of power

Status

* My investment doesn’t create a specific asset I can point to as “owning” which makes it more difficult to gain the respect of others (unlike a factory, supercomputer, etc.)

Trust

* It’s harder for me to tell which intangible asset business proposals are real and which are budget grabbing “scams.” Will this return actually happen or am I being tricked?

Of course it is very difficult to really know what is going on in the minds of decision makers but perhaps this gives us a few concepts to test.

Purpose

I am interested in how people make decisions, especially those decisions that surround the creation and commercialization of innovation. For me, I hope blogging will be a way to express my interests and ideas (no matter how naive) and that the process will stimulate discussion. If we are lucky we may discover something new about how people think.

"Prospect Theory" is an ode to Daniel Kahneman and Amos Tversky who gave us many of the most important advances in modern decision theory. Under this title I will be sharing thoughts on articles, ideas for new research, and examples of innovation decisions from my experience. In "real life" I am a business development executive with a major research lab so I have lived some of the theory we will be discussing. I hope you find it valuable.

More to come at www.prospecttheory.net