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People complain about company profits, the effect of the products that they make on our lives, and the pay gap between the people at the top of the firm, and those underneath them. But rarely do we hear complaints that a company is spending too much money on R&D (except for the oddly concerned shareholder). Research and development are viewed positively by society, thanks to the fact that it generates massive returns that everyone can enjoy.
From the outside, it seems like R&D is worth it. But should entrepreneurs blindly engage in expensive projects in the hope that they will pay off? That’s a much more difficult question to answer.
What Do The Data Say?
Every company faces an internal battle. On the one hand, firms know that if they spend more money on R&D, then they can improve their products and deliver a better experience to consumers in the market in the future. Typically, customers will be willing to spend more on better products, helping the firm charge a hefty markup and claw back its costs. On the other hand, R&D spending cuts into net earnings – the profitability of the firm. Shareholders, therefore, are typically reluctant to allow publicly-traded companies to engage in substantial R&D unless they believe that it will generate a considerable return in the future.
The data, however, appear to indicate that shareholder concerns are unfounded. In a study of the top 100 Thomson Reuters Global Innovators, researchers found that those companies that spent more than double the average proportion of their income on R&D saw a corresponding doubling of the growth rate of their share price over the intervening years. Double-spenders had an average annual growth rate of their share price of an impressive 12.6 per cent, compared to the average 6.85 for the S&P 500 as a whole.
What Does This Mean To You As An Entrepreneur?
Okay, you might say, it’s great that large companies that have big R&D budgets see returns from their investments. But the likelihood is that you’re not at the head of a major company R&D department: you’re just a person who is starting up their firm and wants to know whether investing in R&D is worth it.
Whether it’s worth it depends on your view of value. Many of the most successful entrepreneurs in history, like Bill Gates, didn’t actually invent the technologies on which their platforms were based. Gates, for instance, bought the DOS operating system from a Silicon Valley company for $50,000. Gates saw the potential of the platform and decided that it was worth parting with his hard earned cash. Likewise, Zuckerberg didn’t invent the internet. He just layered his social media platform on top of it, creating value in the process.
You could take the view, therefore, that it doesn’t really pay to do R&D yourself as an entrepreneur. It’s far more lucrative to figure out ways of developing products using existing technologies. Your job is to seek out new value in places where it hasn’t yet emerged.
That’s just one school of thought. The other says that the only value that a startup has are its secrets: the things that it knows how to do that nobody else does. It’s incredible when you think about it that Mark Zuckerberg in his dorm room at university could do what a giant company like AOL could not. AOL in the late 1990s and early 2000s was one of the largest internet companies in the world, well-positioned to develop new and exciting products that would change the market. It didn’t because it lacked a specific vision.
Startups, therefore, which focus on R&D, can create something truly valuable. Startups that can protect their knowledge and use it to their advantage can extract monopoly profits from the market. Tesla is an excellent example of this. The company shares a lot of its IP, but exactly how the company makes its batteries so cheap and reliable is still a mystery to many, even academics who study battery chemistry.
Why Not Just Wait For The State To Create New Tech?
Putting together a research laboratory is expensive. You need building space, microplate equipment, and a team of highly specialised and costly workers. Why would you bother? Why not just wait for universities to create the technology that you need and then just piggyback on that? After all, that’s how many of the most intelligent people in tech got their break.
It turns out, however, that looking back with hindsight and trying to find patterns might not be a good idea. It seems as if Mark Zuckerberg made the right decision to layer his social network technology on the internet and avoid going to the trouble of investing in R&D himself. But it doesn’t necessarily mean that that was the right decision. It might have just been a gamble that happened to pay off.
If you look at many of the most successful and entrenched firms in the world, they tend to have something in common: they’re not afraid of investing a lot of resources into R&D, so long as they can create something valuable.
Take Deep Mind, the London-based AI startup. The company didn’t sell much at all during the first four years of its existence. It merely set itself up as an elite AI research and development centre, hoping that it would stumble upon new AI methods which it could then use to boost its value to major international firms. As it happened, that’s precisely what happened when Google bought it for $400 million in 2014. Deep Mind promises to create artificial brains for the search giant, but nearly a decade into its existence is yet to produce a viable product for the market.
So is R&D worth it? Well, it all depends on your view of business. If you want ownership of the IP, then yes. If you’re prepared to buy it, then probably not.
This is a collaborative post.