Why Spend Money on R&D And New Projects? And How to Set Realistic Goals
Hello! I’m Max Volokhov, Chief R&D Officer at Mitgo. For 15 years, we’ve been researching various forms of corporate innovation. We launched our in-house startup studio, set up an investment fund, created new businesses within the company, and conducted several M&A deals. All of this deserves separate stories (some of which, by the way, I’ve already described in my blog — https://maxv.tech/), but today let’s talk about R&D in general and effective methods for working with innovation within the company.
R&D (Research & Development). By this, I mean innovation, new businesses, new products, directions, new services, etc.
But why do all of this? Isn’t it better to invest in what already exists, in maintaining the status quo — less risk, more conservative approach, and proven solutions that have been used for years and generations!
How many times have similar thoughts visited many CEOs and almost all CFOs (whose job is to fend off those who want to squander the corporate treasury on ideas and projects with unclear prospects)?
How many times have leaders, unable to find an answer to this question, fired entire innovation departments, cut projects?
Is there an answer to the question “Why do all of this?” I will offer my version.
Later, if the answer seems reasonable to you, we will discuss how to allocate funds for R&D wisely, down-to-earth, transparently, and with the right expectations for the results.
Important Announcement
I describe what I know about — corporate R&D, venture capital, and entrepreneurship within IT companies. If you are in a different niche/industry, apply my experience with adjustments for your industry at your own risk.
Everything described below is the result of our experience: how we at Mitgo approach structuring R&D activities.
Why spend resources and time on R&D?
The most important question, or rather, a strategic decision. Let’s consider the answer to this question from the perspective of risks and alternatives.
So, simplifying, there are only 2 scenarios here — A) You spend resources on R&D;
B) You save on R&D. Let’s leave aside scenarios where everything goes well, you create new unicorns in batches, everyone is happy and sails into the sunset on yachts, rowing new Ferraris instead of oars.
What can happen in a negative scenario?
In option A), when you spend resources on R&D, the worst that can happen is that you will lose all the invested resources. R&D is an unpredictable thing, you should understand that it may not work at all, and all the funds spent on it will go down the drain.
Terribly unpleasant.
Now, option B), you don’t invest in R&D and live off what you have.
Here the worst scenario is the death of your company. It so happens that there is nothing eternal, and if you don’t develop, your competitors, both direct and indirect, will develop to kick something out of you at one beautiful moment.
Let’s compare negative scenarios.
A) Loss of money VS B) Death of the business
If you have read Nassim Taleb, or, in general, have common sense, it will not be difficult to add 2+2 and understand that these are asymmetric and completely incomparable risks.
Essentially, your choice is whether you are willing to pay to avoid death?
If the risk of losing money is more important to you than hedging the risk of death, there is no point in reading further. Sorry to have wasted your time.
For those who understand that even non-guaranteed risk prevention of death is orders of magnitude more important than savings — let’s continue.
Now that we have figured out the main strategic decision, let’s talk about how not to let R&D become a bottomless budget hole and a cover for bad ideas and strategies. Unfortunately, this is common in our industry. It is the peculiarities of working in a zone of uncertainty and long cycles until results.
Aimless R&D and theater of innovations instead of specific results is a common thing. Sometimes consciously, but much more often due to a lack of competence in the matter.
However, let’s move on to more tactical tasks of structuring, categorizing, and focusing.
How to divide R&D activities in a company? Structure.
If we are talking about a company that already has one or several established businesses/products/services and is thinking about its future, then there is an option to divide R&D into two parts. For simplicity, let’s call them: Internal & External
Part 1. Internal R&D
This is the part of R&D that should be created within an existing business unit. Usually, this is iterative improvement of what already exists. New features, additional services, related products for the same audience, and other activities. The goal of internal R&D is to keep the product relevant and have the necessary characteristics to increase sales/usage/geo expansion.
*Advice. Internal cannibalization team.
Every large business should have a team inside with the goal of creating a product that can eat/defeat your existing product. The logic here is simple — it’s better to do it yourself than to wait for your competitors to do it. As soon as you make version 2.0 of the product that eats your version 1.0, a new team is immediately launched with the goal of creating version 3.0 and so on.
Part 2. External R&D
These are teams whose task is to create fundamentally new products, enter new markets, work with the highest level of uncertainty, and use it to their advantage. Until humanity invents something better, the Portfolio approach is the best approach to working with markets with high uncertainty. This is when you make not one large investment in the zone of uncertainty, but 10 small ones, with the calculation that 1 of them will hit and pay off the 9 unsuccessful ones.
Various formats can be included in the External R&D category: internal incubators, startup studios, as well as open innovation tools: venture capital funds, accelerators, and other hybrid forms for interacting with startups in the market.
*Advice. Benefits and harms of predictability.
A business unit is considered predictable when its growth rates, evaluation, and prospects are mathematically calculable. This is either already incorporated into the unit’s price (if it’s a business you are considering buying), or you simply understand its growth limits — it cannot grow more than X. If the size of the market allows, this is great. You can focus only on capturing it, without losing focus, but more often the situation arises when you want more, but there is nowhere to start.
If the unit has a level of unpredictability, then, in addition to risks, it can also provide a reward, as growth is not limited by calculation frameworks.
Where are the boundaries? How to divide the first and second.
The restriction here is simple. There is the good old Ansoff matrix that divides based on two criteria: Existing product/service or New, and Existing market (where you already operate) or New.
Internal R&D teams go to zones 1, 2, 3, but never 4.
External R&D teams only go to zone 4, sometimes to zone 2 if there is an agreement with the business unit to provide access to the audience (resulting in something like a Joint Venture).
What can be the right goal for R&D?
For this, we need a tool called Growth Gap.
Growth Gap is the difference between what you have and can calculate, at least roughly, and your potential or simply the goals you may have for various reasons.
For example, your current businesses, products, and services will grow 10–20% year-over-year. Plus, you plan for a small geo-expansion and a couple of new products. The more uncertainty and less predictability, the more we discount (lower revenue forecast).
In the end, you will have a figure that if everything planned works out, even with a discount for risk, in 5–7 years, you can grow to size X. But this is not enough for you, or there are reasons why you need to be X2.
The difference between what you need and what you get is the Growth Gap. It is precisely the right goal for R&D.
To be precise, Internal R&D should maximize the Calculated line, while External R&D should build things that can cover the Growth Gap.
Why is Growth Gap the right goal for R&D? These figures are transparent; they can be explained to the team at all levels — why exactly these target indicators and how they are related to the entire company and its strategy, tied to the company’s revenue, not abstract metrics. These goals can be decomposed into separate sub-teams and growth tools.
*Tip. Revenue or capitalization?
In these crisis times, I suggest defaulting to calculating Growth Gap in revenue figures. But if fast growth is more important in your situation, it makes sense to calculate Growth Gap in terms of capitalization of existing and new businesses.
This small change will drastically affect what projects you create, who you invest in, and on what terms. Think about it and decide what is more relevant in your case.
How to work with Growth Gap. Examples and practice
To cover GG, the external R&D tools described above exist. If we clarify, we can divide them into 3 parts:
- Portfolio asset creation internally (incubators, startup studios), or collaborating with startups and investing in them (venture funds, accelerators).
- M&A, purchasing companies in their entirety. Convenient, but expensive and with more risks than it may seem (70–90% of M&A fail to achieve their calculated goals ).
- Partnerships. Without being a shareholder, you can also earn big. As an example, Pfizer earned $37+ billion selling the COVID vaccine, developed by a company that did not belong to the giant. Or the App Store, earning on every transaction of applications developed by developers who are not part of the Apple ecosystem.
Which tools to use is very individual. If innovation and creating something new is an unfamiliar discipline for you, I would recommend focusing on partnerships and M&A. For those who are more advanced, venture capital can become a very flexible and powerful tool.
How can this work in practice?
For example, let’s say our Growth Gap is $100 million.
We know how to invest in startups, so let’s assume that by investing $50 million in 10 projects (average stage, Series A+), we can find one that will earn $60 million in the fifth year after the investment.
Our startup studio, creating a Seed-level business from scratch for $1 million, can issue 10 startups (early-stage Seed). Since the survival rate of projects from startup studios is generally higher, let’s assume that 2 of them can earn $10 million each after 5 years.
Intermediate calculations: the venture fund will provide $60 million with costs of $50 million. The studio will bring in $20 million with costs of $10 million. Total revenue is $80 million, total cost is $60 million. Then we need to build the process and test partnerships with other companies, which will bring in an additional $10 million in sales. Let’s say this will cost $5 million. So, the total cost is at least $75 million.
Final result:
Intermediate calculations:
Compare this approach with the traditional R&D approach of just creating and hoping for a breakthrough. Here, we have specific tools and responsibilities for achieving our goals. Everyone has their own objectives and resource requirements, and we can break them down into daily tasks if necessary.
Is it guaranteed to work?
No. But, firstly, deviations from goals will be noticeable, and data should be updated regularly and reviewed to make corrections to the set of tools and budgets (at least once a year). Secondly, if there is no guarantee, can we simply not engage in R&D? Yes, we discussed the main risks at the beginning, but consider your alternatives.
Let’s say you were planning to spend $75 million on R&D, but instead of creating new sources of revenue, you put the money in a bank or bought bonds. Interest rates are currently low, and in 5–6 years, you will barely recover your funds, just covering inflation. At the same time, you haven’t made any progress in terms of product and business, and you are 5 years closer to the end of your current business, which earned you these $75 million.
Or, you invested these funds in stocks. Essentially, you handed them over to companies that know how to grow and work with R&D. Congratulations, you just sponsored your own competition.
If this perspective suits you, that is also a choice. It is good if you made this choice consciously.
Conclusion
To summarize, in most cases there is no choice whether to engage in R&D or not.
The situation is very reminiscent of Churchill’s famous quote:
“Democracy is the worst form of government, except for all the others”
The same can be said for R&D — it’s terrible, difficult, long, unpredictable, expensive, and super risky, but the alternative is the death of your business or sponsoring the development of your competitors.
Therefore, it is necessary to engage in R&D, and the key focus should be on making this difficult journey at least transparent, divided into stages, and understandable in terms of goals, tasks, and implementation tools.
Then, perhaps, the results will not be so long and bad ;)
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