HOW INNOVATION REALLY

WORKS
SUMMARY OF THE BOOK “HOW INNOVATION REALLY WORKS”
BY
ANNE MARIE KNOTT

THIS RESEARCH IS SPONSORED BY NSF

2017
 DEFINITION
According to NSF:
• Basic research is a systematic pursuit of new knowledge
without specific immediate commercial application.
• Applied research is a planned, systematic pursuit of new
knowledge aimed at solving a specific problem or meeting a
specific commercial objective.
• Development is the systematic use of research and practical
experience to produce new or significantly improved goods,
services or processes.
 DATA/FACTS ON R&D
• In the US, in 2016 top 1000 R&D spenders invested USD 680 billion in R&D up 5% from
the prior year. 63% companies are overinvesting and 33% are underinvesting in R&D.
• Less than 5% of startups obtain Venture Capitalists financing, and of those that do, only
25% return their investment capital. So when we think startups, we are likely ignoring
98.75% of companies.
• The money companies spend on R&D is producing fewer and fewer results. In fact, the
return to companies R&D spending have declined 65% over the past three decades.
Only 2 out of 125 R&D projects reached its commercial success.
• According to Business R&D and Innovation Survey (BRDIS) indicates 3.4% of
outsourcing R&D is to universities, 81.3% is to companies, and the remaining 15.2% is
to government agencies and other institutions.
• Large companies differ from small companies is that they conduct more basic research.
The vast majority (82%) of R&D in companies is development.
• Small companies invest less in R&D. Bill Gates did not develop DOS, he bought it for
USD 50,000 from Seatle Computer Co. Similarly, Steve Jobs imitated the Graphical User
Interface after seeing it at Xerox PARC and hiring employees who had formerly worked
at PARC.
 FLYING BLIND
• There is no question that innovation is important. Innovation is key to
companies growth. R&D has been viewed as engine of economic
growth.
• Despite the importance of innovation to companies as well as to the
broader economy, despite the growth in real R&D by both the
government and companies, and despite all the expert dedicated to
helping companies innovate, companies have become worst at it.
• The return to companies R&D spending have declined 65% over the
past three decades and coincidentally this decline coincides closely
with the decline in US GDP growth over the past 30 years.
• This book propose Research Quotients (RQ) solution.
 MISCONCEPTION
• MISCONCEPTION 1: Small Companies Are More Innovative

• MISCONCEPTION 2: Uncontested Markets Are Good for Innovation

• MISCONCEPTION 3: Spending More on R&D Increases Innovation

• MISCONCEPTION 4: Companies Need More Radical Innovation

• MISCONCEPTION 5: Open Innovation Turbocharges R&D

• MISCONCEPTION 6: R&D Need to Be More Relevant

• MISCONCEPTION 7: Wall Street Reward Innovation

 MISCONCEPTION 1
Small Companies Are More Innovative
• The reality shows that large companies are more innovative than small
companies.
• Large companies have scale and scope of economies that allow them to better
generate and exploit innovation.
• These advantages cause large companies to favor incremental and process
innovations because these forms of innovation benefit more directly from the
scale advantages.
• The source of misconception: (1) People confuse small companies and young
companies, and indeed companies are more innovative when they are younger;
(2) People only see the successful young/small companies and overlook the other
98.75% of startups that fail to receive Venture Capitalist (VC) funding and to
return at least the invested capital.
• Large companies are the chief of engine of innovation. Not only large companies
conduct 5.75 more R&D in aggregate than small companies, they have 13%
higher productivity with that R&D.
• A further benefit of large company R&D is that it generates the spillovers upon
which small company innovation free-rides.
 MISCONCEPTION 2:
Uncontested Markets Are Good for Innovation
• The fact shows that Blue Ocean Strategies lead to high profits, but low levels of
innovation.
• The return to this monopolists innovation are low because ultimately they reach
a point where they have brought all the profitable customers into the market. The
remaining customers require either extremely low price or an extremely high
level of performance.
• Once the monopolist reaches that point, the cost to bring in additional cutomers
exceeds the profits from those customers.
• Lack of innovation makes the monopolists market attractive to new entrants.
• While such monopolists need to be vigilant that natural incentives do not work
against their innovating, they need not be doomed. They can create competition
for themselves to force innovation such that to form of creating future clones,
where the company both innovates and continous to enjoy monopoly profits.
• For companies to remain innovative, the most straightforward strategy is to seek
out Porters “4 Diamonds” markets that makes companies continously innovate
because their life depends on it.
 MISCONCEPTION 3:
Spending More on R&D Increases Innovation
• Tax credit indeed increase investment on R&D but it won’t solve the
problem of increasing innovation and growth. The fact of the matter 63%
of companies are already overinvesting in R&D.
• For 33% of companies that are underinvesting should not need tax credits
to increase R&D. Increasing R&D will increase their profits even without tax
credits.
• Shareholders in companies that are overinvesting on R&D increase the
value of their stock by having those companies cut overinvestment.
• Shareholders in companies that are underinvesting on R&D increase the
value of their stock by having those companies increase their R&D.
• These corrections increase companies profits, the government gains
corporate income tax on the higher profits and capital gains tax on the
additional shareholders wealth. So the government increases revenues and
saves the tax credits.
 MISCONCEPTION 4:
Companies Need More Radical Innovation
• Large companies, those with central labs doing basic research, are going to
generate the seeds for most radical innovations.
• These radical innovations will typically have lower returns than more incremental
innovation, and thus will be part of 123 of 125 projects the company abandons.
• In some cases, startups will exploit these innovations. Thus, small companies will
be disproportionately associated with radical innovation, even though the
underlying technology for the innovation is likely to have originated in a large
company.
• While most of those startups will fail to recoup their initial investment, those that
succeed will have outsized returns. Microsoft and Apple are very good examples.
• Large companies get higher returns, entrepreneurs have a stock of abandoned
innovations to exploit, and the economy gets radical innovations.
• Is there a way for large companies to better capitalize on the 123 projects they
abandon? The answer may be yes.
 MISCONCEPTION 5:
Open Innovation Turbocharges R&D
• There is a widely belief that open innovation increases companies financial
performance.
• Accordingly, open innovation has been adopted by the vast majority of
companies engaged in R&D, there has been a 2050% increase in the amount of
outsorced R&D.
• There is some evidence that open innovation in the form of idea sourcing may
improve companies financial performance, the record on idea development
indicates that R&D outsourcing not only fails to improve financial performance
but it actually degrades it.
• This occours because outsourced R&D incurs R&D expenditures without
increasing revenues. Thus it decreases profits. Worse, however, it appears that
outsorcing R&D is a slippery slope wherein company innovative capability decays,
so the company increasingly outsources, and capability decays even further.
• These mechanics are so powerful that outsorced R&D accounts for much of the
65% decline in R&D Quotients. If companies are willing to undertake the
investments to recreate labs and rebuild their technical staffs, over time they
should be able to restore RQ to prior levels.
 MISCONCEPTION 6:
R&D Need to Be More Relevant
• In 1980s and 1990s a number of economic forces led to widespread
decentralization of R&D. The logic of decentralized R&D is that it
makes companies more responsive to the market.
• 80% of consultants and 90% of investment professionals believed
decentralized R&D is associated with higher RQ. In fact the opposite is
true: companies with centralized R&D have 40 % to 64% higher RQ
than companies with decentralized R&D.
• Centralized R&D tends to: (a) do more basic research, so are more
likely to create new technical possibilities; (b) create technology that
benefits multiple divisions, and (c) derive more of their technology
from internal R&D rather than through outsourcing.
 MISCONCEPTION 7: Wall Street Reward Innovation
• The Wall street reward companies growth not innovation.
• The first way RQ helps companies is by telling them how much they
should invest in R&D. However, if investors do not know how the
increased investment translated to market value, companies may not
have discretion to expend additional funds.
• Fortunately RQ defines the relationship between companies R&D and
their market value. So investors should know companies RQs to check
wether companies overinvestment or underinvestment on R&D.
• By knowing RQs investors play critical role in restoring economic
growth even though they do not invest in R&D directly, they influence
the behavior of companies that do.
 THE RESEARCH QUOTIENTS (RQ) SOLUTION
The production function:
Output = CAPITAL x Labor ................................................................ Eq. 1

The production function to generate RQ:

Output = CAPITAL x LABOR x R&D x Spillovers x Advertising ............ Eq.2

For company i, the Eq.2 become:

Output = CAPITALi x LABOR i x R&D ix Spillovers i x Advertisingi .......... Eq.3
The definition of RQ is the “company-specific output elasticity of R&D (i in
Eq.3)
CORRELATION BETWEEN RQ AND TFP
CORRELATION BETWEEN RQ AND PATENT INTENSITY
 CONCLUSION
• RQ is the most powerful measure you can construct for a company’s
innovativeness. It is derived from economic theory, and more
important, its behavior matches proposition from economic theory
when tested over 47 years of data. RQ predicts R&D investment,
market value, and revenue growth.
• RQ also has properties that make it useful to companies. RQ is
uniform, it is essentially a ratio of output to inputs, so it can be
compared across busines units.
• RQ is valuable tool for (1) justifying R&D investment to CEOs, the
board and investors; (2) improving the efficiency of R&D; (3)
estimating the value of R&D investment to future growth.