May 13, 2019
The Ongoing Battle of Innovation Financing
You want to innovate, but you can’t pay for it.
It seems like an awkward problem, but has been at the forefront of conversations I have had with several companies as they have been advancing their innovation programs. These are sometimes Fortune 500 companies that are putting millions (or billions) to the bottom line and they say they cannot finance the new thing they are trying to do. Public or private – it doesn’t seem to make a difference.
This led me to an area that is completely foreign territory to someone raised in technology, enterprise architecture and solving complex organization and process problems. Yup. I had to talk to the Finance Department. And the problems I encountered are ones that enterprise IT seems fundamentally ill-equipped to address. This problem space is summed up nicely in Capitalism without Capital: The Rise of the Intangible Economy (Haskel and Westlake, Princeton Press 2018 – the first chapter is available online).
In this book, the authors discuss how intangible assets have entirely different properties titled the Four S’s: Sunkeness, Scale, Synergies and Spillover. Each of these are worth their own blog post, but one key takeaway is that the IT department and their allied digital teams are creating intangible assets that have incredible potential to scale if they are successful. But if they fail, the value is worth almost nothing on the open market – even if the organization gains valuable learnings.
Technology asset development in most companies is funded through capital or operating expense budgets. But unlike physical assets like a manufacturing line or a Cat excavator, if the economic return isn’t realized you don’t have a physical “thing” that can put on the open market and sold for a well-understood value. Which means the failure of a capital project requires a write-off, which becomes a barrier to investment and a perceived risk. ROIs are demanded and have to be defined. Stage gates are setup to minimize the financial exposure. Controls to minimize risk become organizational flags which must be navigated at high speed on the slalom course of development. And the innovation team that cannot manage these risks will likely see their promising project die.
R&D funding allows for this kind of risk management through testing, prototyping, failure and learning. But getting R&D and IT to work together on project funding means creating an organizational partnership that has rarely, if ever, existed.
Barach Lev of Stern School of Business at NYU wrote an article about how financial analysts should take a different approach to firm valuation on the basis of the deployment and development of strategic assets. He specifically cites the use of operating expense funding of intangible strategic assets as a negative indicator in traditional OPEX models: “the marking to market of assets and liabilities…and rules requiring the write-off of impaired assets and goodwill are examples of recent accounting regulation that requires substantial managerial estimates. These estimates, often unreliable and sometimes manipulated, significantly exacerbate the noise and inconsistency of reported earnings…that have no bearing on future performance and growth.” (Feng Gu & Baruch Lev (2017) Time to Change Your Investment Model, Financial Analysts Journal, 73:4, 23-33, DOI: 10.2469/faj.v73.n4.4). This idea is more completely developed in their provocatively titled book, The End of Accounting.
The Economist reported on this trend in late 2017, but ideas take a long time to percolate from the financial community, to the advisory firms, to the CFO, to the internal innovation teams and finally, to IT. And if the CFO isn’t taking the lead to change the behavior of the organization, IT finds themselves having to fight against the wind of corporate finance and compliance. It’s hard to manage to that risk and many projects then fail to scale meaningfully. Ultimately, this creates the space in the market for a firm with less risk-averse challengers that rewards speed to scale and ideation over financial predictability to win.
If you find yourself in this position, I recommend taking the following steps to help with innovation/financial alignment:
If you are a senior IT leader, make sure you can communicate in the basic language of finance. Understand OPEX, CapEx and how the FASB guidelines in January 2019 changed.
Do you understand the financial priorities of your organization, how IT expenses and projects are being funded and how this aligns to the CFO’s goals? If not, buy someone a lunch and get up to speed on how funding models may shift as IT spending and investment shifts along with innovation projects.
Push, and push more if a digital transformation/IoT/digital platform project is being funded by IT OpEx budgets without an investment from the business.
Do you have a person in finance or IT that helps align the contracts, spending and budgets between IT and the finance team? Leasing, SaaS, OpEx and capital requirements have changed. The IT Financial Analyst is an important parallel to the other governance disciplines of Enterprise Architecture and the EPMO/Agile Program office.
Don’t let procurement and contracts dictate your technology strategy. If you are in this place, it is an organizational acknowledgement that technology procurement is a commodity. Some components of technology are commoditized, but organizations where IT doesn’t lead with a business conversation begin lagging in the innovation space and find themselves delivering less value, or being constrained by budgets and controls tailored to their former way of delivering technology to the business.
So, you find yourself here. Your innovation team has a great idea. Your digital team wants to innovate to drive customer value. Your IT team is building an IoT platform for a new class of connected products that will position your company as a market leader. Will finance stand in the way, or will the executive team including the CFO give permission to think and do differently?