Investment in the Future: How should the board prioritize R&D spending?
By Margaret Steen

Research and development (R&D) spending has been at the heart of many of the United States’ technological advancements, but over the last 20 years China has made a greater investment in technology.

According to a National Academy of Sciences report, federal R&D funding as a percentage of gross domestic product has dropped 54% in the last 40 years. And while private industry has picked up the mantle to some extent, most of this research is in search of new products to take immediately to market.

Whether a corporation is willing to invest in R&D largely comes down to a single issue — how does the company prioritize long-term gains and short-term payouts?

R&D in-house
Some industries seem more likely to have a higher R&D budget than others.

A pharmaceutical company will invest heavily in drug discovery, for example, and an aviation company may invest in a next-generation engine. In both cases, returns on the R&D investment can be many years out. Companies will likely invest in unique applications, but not in basic science like artificial intelligence research or cloud infrastructure, says Dinesh Paliwal, a partner at KKR, who serves on the boards of Raytheon Technologies and Nestle.

Boards should keep the pressure on CEOs to seek out disruptive technology, he says. To do this, directors can set aside money for the CEO or CTO to allocate toward innovation or use their own labs, engineers and customers to develop the technology of the future.

“If you can find a rhythm to do disruptive technology development within the company — nothing beats that,” Paliwal says. “If you have one blockbuster idea in five trials, that’s going to be an incredible gain for the company and shareholders.”

It’s also important to evaluate these potentially disruptive ideas while in development, so the ideas that aren’t working are killed in a timely manner, Paliwal says.

Ford Motor Co. director Kimberly Casiano says that company’s future success will require “an incredible pool of exceptional human capital.”

To help attract and foster that talent, Ford purchased one of Detroit’s iconic buildings, the former Michigan Central Station, and plans to transform it and some surrounding properties into a “mobility innovation district” — a campus to attract the brightest people in the industry, with space for Ford, Ford’s partners and other companies, including startups.

This investment illustrates the complexity of the choices companies face as they decide how to spend their money. It is not a direct investment, but “it’s setting the stage for future R&D,” Casiano says. Looking broadly at how expenditures fit with a company’s strategy is important, she says.

“A corporation’s available resources for capital investments are finite,” she says. “Historically, R&D is the most obvious recipient of capital investment. However, in today’s world with technological disruption and supply chain disruption, capital must be deployed on several fronts.

“Capital can be used for acquisitions, joint ventures or other types of partnerships with innovative, cutting-edge companies. Capital can also be used to shore up the supply chain, especially in terms of visibility throughout the supply chain, risk mitigation for single-source supplies and minimizing geographic risks. However, even in the worst of economic times, R&D must never fall by the wayside.”

“We now have to look at how we can manage and plan for disruption as part of our business cycle,” says Gary L. Evans, professor of business at the University of Prince Edward Island. “How can we build this into our growth model for the future? Not every business has to be Blockbuster and get wiped out by Netflix.”

It’s not easy to track and evaluate new technologies, however. “We don’t know who the winners or losers are going to be — we don’t even know what kind of new businesses are going to come up,” Evans says.

Long-term investment or short-term payout
At times, companies may have more cash than they need for operations or acquisitions. That can be a time when stock buybacks or dividends are appropriate, but they should not take the place of innovation.

“You have to think about the needs and motivation of all shareholders,” Paliwal says. “Some want sustainable dividends, but they also want the long-term share price appreciation, while others may want to see a quick pop in share price with a larger buyback, which may be counterproductive to strong R&D investments.”

Keeping the share price up requires a pipeline of new products — which requires investment.

“I think the investor community has expectations that when dividends are paid out, the company has still allocated sufficient funds for R&D,” says Jim DeLoach, managing director of the consulting firm Protiviti. “Everyone and their uncle knows that innovation is vital to long-term success. If a company is spending a significantly lower percentage of its revenue on R&D than its competitors, I can tell you who will win and who will lose over the long term.”

It’s easy for shareholders and even board members to become focused on short-term results. But thinking about the company’s long-term success is “built into the very concept of being a director,” says Michael Useem, professor of management at the Wharton School of the University of Pennsylvania. “Your obligation is to think about the company five to 10 years out.”

A company needs shareholder buy-in for longer-term investments like R&D for multi-year technology development. The key is to have a persuasive story that explains why these R&D investments will pay off in the mid to long term — and reach out to shareholders regularly to tell that story.

“Shareholders are smart people,” Paliwal says. “If they don’t understand the strategy, of course they will ask for dividends and buybacks.” But if board members and the CEO present a solid plan, there will likely be less focus on immediate results.

“Break it into milestones so shareholders can follow that you’re executing on the strategy and making progress,” he adds.

“Even though we live, sadly, in an environment where short-term guidance is important to Wall Street, we as a board — even if things may hurt us in the short term — take a long-term view,” Casiano adds.

Long-term tracking of R&D could give directors an idea of what current research could bring by monitoring how much of the company’s revenue is coming from recently developed products as opposed to older ones. The exact proportion that indicates success will likely vary by industry and by company, but it is a metric that can help measure R&D success over time.

“The board wants confidence that results will be obtained,” DeLoach says. “What’s the return on R&D investments?”

Buying the results
Acquisition is yet another way for a company to keep up with technological innovations. This strategy can fast-track developing and scaling research results.

“Almost every day, you pick up the paper and you see larger firms buying the fruits of smaller companies’ R&D efforts,” DeLoach says. For example, major banks will acquire financial technology firms. “They’re acquiring new market entrants who are successful and innovative.”

Essentially, these companies are outsourcing some of their R&D to smaller startups, then acquiring the ones that are successful.

“But you have to be very careful here,” DeLoach says. “No firm can expect to acquire all the innovation it needs. In fact, there’s research that suggests that a sole emphasis on acquiring your way to innovation doesn’t work.”

Companies need, then, to choose their acquisitions carefully — and not let acquisition expenditures crowd out in-house R&D.

Boards should ask probing questions about potential purchases, notes Useem. Issues include the retention of the acquired company’s management and employees and whether the purchase price is right. CEOs “want to go to the board not as a formality, but to get an informed and tough-minded review of what they plan to do,” he says.

Conferring with management and overall strategy is the board’s purview and, as such, directors need to be mindful of the company’s position on R&D.

“Boards in many cases have become — and in all cases should become — a partner with management at the big decision table,”  Useem says.

 

Keys to Success: Experts identify several strategies for boards looking to optimize R&D spending

Put the right people on the board

Good boards are diverse — not only in terms of gender and race but also in terms of experience and knowledge. It can also be very helpful to have board members with deep knowledge of the company’s products and industry.

For example, companies that use medical research can benefit from having board members who can “ask highly informed questions of the CEO and the head of research at the company,” says Michael Useem, professor of management at the Wharton School of the University of Pennsylvania. These board members can also translate scientific issues for the rest of the board — and they can bring fresh research ideas to the company.

A digitally savvy board of directors can mean the difference between a company that uses technology as just one resource to execute its strategy and a company that sees technology as a driver of improved operations.

Research has shown that companies with digitally savvy boards — which means at least three board members with “an understanding of emerging technologies and how those technologies will impact the success of the business over the next decade” — outperformed those whose board members were not as attuned to technology, says Jim DeLoach, managing director of the consulting firm Protiviti.

It’s also important to have board members who work well together, creating a culture that fosters good decision making and tough questions.

“Maybe instead of investing in another acquisition, we should be investing in our infrastructure,” says Gary L. Evans, professor of business at the University of Prince Edward Island. “If you’ve got a good chair who knows how to get the most out of every single board member, you’re going to have a fantastic board.”

Build an innovative, customer-focused culture

Whether a company is developing its own innovative products through R&D or acquiring companies that have developed promising technology, it’s critical to understand what will improve the customer experience. This will help direct R&D and can help clarify which innovation strategies and acquisition targets make sense.

“There is no substitute for a strong focus on the customer experience, and all the initiatives to improve processes, products and services continuously should be based on data around the customer experience,” DeLoach says. “How does management know what customers are thinking? How effective is the company’s innovation culture in empowering and rewarding employees to vet new ideas and take appropriate risks to make those ideas a reality?”

This innovative, customer-focused culture can help even smaller companies that can’t afford the huge R&D operations of large technology, pharmaceutical or automotive companies.

Maintain flexibility

Every capital investment decision requires weighing alternatives.

“We’re looking at trade-offs, we’re looking at opportunity costs,” says Kimberly Casiano, who serves on the boards of Ford Motor Co. and Mutual of America.

It’s good to consider the return on investment of any expenditure a company makes. But some investments generate a clearer ROI than others, and it’s also important not to take too rigid an approach.

“It’s important to maintain flexibility and not come up with formulas that tie your hands,” Casiano says. “You have to be able to respond to what’s happening in the environment — and you have to be able to respond to new opportunities that may come up.”

Margaret Steen is a freelance writer in the San Francisco Bay Area focused on business and technology. She is a frequent contributor to Directors & Boards.


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