NIST GCR 02–841 Between Invention and Innovation

NIST GCR 02–841
Between Invention and Innovation
An Analysis of Funding for Early-Stage Technology Development

EXECUTIVE SUMMARY

MOTIVATION

Technological innovation is critical to long-term economic growth. Most technological innovation consists of incremental change in existing industries. As the pace of technical advance quickens and product cycles compress, established corporations have strong incentives to seek opportunities for such incremental technological change. However, incremental technical change alone is not adequate to ensure sustained growth and economic security. Sustained growth can occur only with the continuous introduction of truly new goods and services—radical technological innovations that disrupt markets and create new industries.

The capacity to turn science-based inventions into commercially viable innovations is critical to radical technological innovation. As economist Martin Weitzman has noted, “the ultimate limits to growth may lie not as much in our ability to generate new ideas, so much as in our ability to process an abundance of potentially new seed ideas into usable forms” (1998: 333). Understanding the invention-to-innovation transition is essential in the formulation of both public policies and private business strategies designed to convert the nation’s research assets more efficiently into economic assets.

Definition of terms:
We use “invention” as shorthand for a commercially promising product or service idea, based on new science or technology that is protectable (though not necessarily by patents or copyrights). By “innovation,” we mean the successful entry of a new science or technology-based product into a particular market. By early-stage technology development (ESTD), we mean the technical and business activities that transform a commercially promising invention into a business plan that can attract enough investment to enter a market successfully, and through that investment become a successful innovation. Because innovations must be new or novel, we restrict the definition of ESTD in the corporate context to products or processes that lie outside a firm’s core business interests. The technical goal of ESTD is to reduce the needed technology to practice, defining a production process with predictable product costs and relating the resultant product specifications to a defined market.

OBJECTIVES

The purpose of the Between Invention and Innovation project is to support informed design of public policies regarding technology entrepreneurship and the transition from invention to innovation by providing better understanding of the sources of investments into early-stage technology development (ESTD) projects.

Most of the federal investment into R&D supports basic scientific research carried out in university-affiliated research laboratories. While such investment may lead to science-based inventions and other new product ideas, it is primarily intended to support basic research with potential to generate fundamental advances in knowledge. In contrast, most venture capital and corporate investment into R&D exploits science-based inventions that have already been translated into new products and services, with specifications and costs matching well-defined market opportunities.

The basic science and technology research enterprise of the U.S.—sources of funding, performing institutions, researcher incentives and motivations—is reasonably well understood by academics and policy makers alike. Similarly, corporate motivations, governance, finance, strategy, and competitive advantage have been much studied and are relatively well understood. But the process by which a technical idea of possible commercial value is converted into one or more commercially successful products—the transition from invention to innovation—is highly complex, poorly documented, and little studied. This project aims for a better understanding of this important transition, by seeking the answers to two sets of questions:

APPROACH

We have pursued two approaches in parallel to arrive at a reasonable estimate of the national investment in early-stage technology development: first, learning from the observations of practitioners in the context of a series of workshops held in the U.S., and second, collecting the data available on early-stage technology development investments from other studies and from public statistical sources. These approaches were supplemented by four case studies conducted by a team of Harvard researchers and by a set of thirty-nine in-depth interviews of corporate technology managers, CEOs, and venture capitalists conducted on our behalf by Booz Allen & Hamilton.

Participating practitioners in the workshops included venture capitalists; angel investors; corporate technology managers; university technology licensing officers; technologists; entrepreneurs; representatives from the Advanced Technology Program (ATP) and the Small Business Innovation Research (SBIR) program; representatives from federal agencies and private firms engaged in gathering and organizing data on private-sector R&D investments, such as the National Science Foundation, the Census Bureau, and the National Venture Capital Association; and scholars who specialize in the study of technological innovation and entrepreneurship.

The four case studies examined in detail the experiences of selected workshop participants in managing the invention-to-innovation transition.

The thirty-one companies interviewed by Booz Allen & Hamilton represent a cross-section of large and mid-size firms from among the 500 U.S. firms with the highest R&D expenditures. Distributed between eight industry sectors—electronics, biopharmaceutical, automotive, telecommunications, computer software, basic industries & materials, machinery & electrical equipment, and chemicals—these companies jointly fund approximately 7% of all U.S. corporate R&D spending. An additional eight interviews were with representatives from leading venture capital firms.

FINDINGS

Most funding for technology development in the phase between invention and innovation comes from individual private equity “angel” investors, corporations, and the federal government — not venture capitalists.

Of $266 billion that was spent on national R&D by various sources in the U.S. in 1998—the most recent year for which comprehensive and reliable data were available at the time of the research, and probably a more reliable benchmark of innovation funding activities than 2000, when markets were at their historic peaks—roughly 14 percent flowed into early-stage technology development activities. The exact figure is elusive, because public financial reporting is not required for these investments. Our method of arriving at a reliable estimate was to create two models based on different definitions of early-stage technology development—one very restrictive (that is, biased toward a low estimate) and the other quite inclusive (that is, biased toward a high estimate). With this approach we conclude that between $5 billion (2 percent) and $37 billion (14 percent) of overall R&D spending in 1998 was devoted to early-stage technology development. The remaining R&D funding supported either basic research or incremental development of existing products and processes.

Although the range between our lower and upper estimates differs by several billion dollars, the proportional distribution across the main sources of funding for early-stage technology development activities is surprisingly similar whether we employ models that are restrictive or inclusive. Given either model, expenditures on early-stage technology development by angel investors, the federal government, and large corporations funding out-of-the-core business technology development are comparable in magnitude (see Figure 1 on page 23.) Early-stage technology development funds from each of these sources greatly exceed those from state programs, university expenditures, and the small part of venture capital that supports early-stage technology projects. Notably—even excluding as we do the impact of government procurement—the federal role in this process is substantial: in our estimates roughly 30 percent of the total early-stage technology development comes from federal R&D sources.

As noted earlier, investments by corporations in advancing established product and process technologies to better serve existing markets comprise a dominant source of national R&D spending. But, as the Booz Allen & Hamilton research team found during this project, corporate technology entrepreneurs who create an innovative idea lying outside their firms’ core competence and interest face risks and financial challenges similar to those faced by the CEOs of newly created firms. While corporations will indeed spend lavishly on technological innovations that support their core businesses, they are systematically disinclined to support technological innovations that challenge existing lines of business, require a fundamental shift of business model, or depend on the creation of new complementary infrastructure.

Venture capital firms are critical financial intermediaries supporting new high-growth firms. Why, then, is the role of the venture capital industry in funding early-stage technology development not dominant? Popular press accounts notwithstanding, venture capital firms are not in the R&D business. Rather, they are in the financial business. Their fiduciary responsibility is to earn maximum returns for their investors. They do this through a complex set of activities that can be summarized as buying firms low and selling them high. Venture capitalists do indeed back high-growth new ventures, and in many cases, though not the majority, they support firms that are bringing radical new technologies to market. However, even when venture capitalists do support technology-based enterprises, they prefer to support ones that have at least proceeded beyond the product development stage—that is, firms that have completed the early-stage technology development that is the focus of this study. As the median size of venture capital deals has increased and the pressure to provide attractive returns to investors in mammoth funds has intensified, venture capital has tended increasingly to flow to projects in later stages of development and to already-proven technologies. For all these reasons, trends in venture capital disbursements should not be confused with trends in the funding of early-stage technology development.

Markets for allocating risk capital to early stage technology ventures are not efficient.

Entrepreneurs report a dearth of sources of funding for technology projects that no longer count as basic research but are not yet far enough along to form the basis for a business plan—a scarcity Dr. Mary Good, former Undersecretary of Commerce for Technology, has termed an innovation gap. At the same time, venture capital firms and other investors are sitting on record volumes of resources not yet invested, with over $70 billion currently undisbursed from funds raised during the boom years. In 2002, several premier venture capital firms have taken the unusual step of prematurely returning money to investors to reduce the size of particularly large funds.

We should not be surprised that technology entrepreneurs experience an apparent shortage of funding while large sums in venture funds remain undisbursed. Whether efficient markets exist on Wall Street may be an open question. However, efficient markets do not exist for allocating risk capital to early-stage technology ventures. One often-cited reason for such inefficiency concerns fundamental limits on the ability of investors in early-stage technology ventures to fully appropriate returns from their investments. We focus on a second reason: serious inadequacies in information available to both entrepreneurs and investors. Early-stage development involves not only high quantifiable risks, but also daunting uncertainties. When the uncertainties are primarily technical, investors are ill equipped to quantify them. For new technologies that have the potential to create new product categories, market uncertainties are also high and similarly difficult to quantify. The due diligence that investors in venture capital funds require of managing partners and that angel investors require of themselves is intrinsically difficult—and getting more so as both technologies and markets become increasingly complex.

Up to a decade is required for the transition from invention to innovation. Given technical and market uncertainties, venture capitalists, angels, and bankers prefer to wait to see the business case for a new technology rather than funding speculation. The technical content of the business proposal must be sufficiently well established to provide reliable estimates of product cost, performance, and reliability in the context of an identified market that can be entered in a reasonable length of time. It is the funding of this technical bridge—from invention to innovation—that is the focus of this study and is the basis for the notion of an innovation gap.

Do government agencies that fund R&D provide the support required to bridge this gap? As noted above, most such agencies fund broad-based basic research aimed at increasing the stock of publicly available knowledge. Thus, the technology entrepreneur who finds it difficult to obtain early-stage funding from venture capital firms may also find it difficult to obtain funding from federal agencies to support the resolution of technical issues required to define and justify a business case.

Despite (or in response to) market inefficiencies, many institutional arrangements have developed for funding early-stage technology development. This suggests that funding mechanisms evolve to match the incentives and motivations of entrepreneur and investors alike.

Champions of early-stage technology projects make use of a wide variety of funding options to keep their projects alive. These include not only successive rounds of equity offerings, but also contract work, income from licensing patents, the sale of spin-off firms, and old-fashioned cost-cutting. While each of these options is associated with its own costs and benefits, entrepreneurs do not play favorites among them when it comes to keeping their projects moving forward.

In contrast to institutional sources of equity and debt capital for advancing existing businesses incrementally, the transition from invention to innovation is financed by a great variety of mechanisms, with new ones being created every day, including angel networks and funds, angel investments backed by bank debt, university and corporate equity investments, seed investments by university and corporate venture capital programs, and certain experimental R&D programs run by federal and state agencies.

A report from the National Commission on Entrepreneurship notes that “the substantial amount of funding provided through informal channels, orders of magnitude greater than provided by formal venture capital investments and heretofore unknown and unappreciated, suggests some mechanisms for filling the gap may have developed without recognition” (Zacharakis et al. 1999: 33).⁽¹⁾ Yet, the proliferation of institutional types is as much an indication of the particular informational challenges and structural disjunctures that define the innovation gap as it is one of a resolution to the challenge.

Conditions for success in science-based, high-tech innovation are strongly concentrated in a few geographical regions, indicating the importance in the process of innovator-investor proximity and networks of supporting people and institutions.

If early-stage technology development investments from all sources are distributed as non-uniformly as venture capital investments, then they are concentrated in a few states and a few industries. This would be expected, for our research results suggest that angel investments are even more locally focused than venture capital. Furthermore, theory suggests that the quality of social capital in the locality where inventions are being exploited is an important determinant of success. Where the social capital is strongly supportive, in places like Route 128 in Boston or Silicon Valley near San Francisco, one might expect not only strong venture capital and angel investments, but a concentration of federal support for early-stage technology development and industry-supported high-tech ventures as well.

While the scope of this research project has not generally focused on funding patterns at the regional and industry sector level, some important trends are apparent (Part II below offers a highly aggregated presentation of early-stage technology development funding flows at the national level).

Geographic Distribution. The geographical distribution of early-stage technology development activity mirrors that of innovation-related activity in general. In particular, early-stage technology development is concentrated in geographical regions that invest heavily in R&D, that possess developed risk-capital networks and related complementary infrastructure (such as specialized law firms and other suppliers), and that otherwise benefit from strong university-industry linkages.

Angel Investors. We found that angel investors provide the most significant source of early-stage technology development funding for individual technology entrepreneurs and small technology startups. Since angel investors make the vast majority of their investments close to home, early-stage technology development activities, particularly those of smaller firms, are likely to be concentrated in regions with active communities of tech-savvy angels.

Role of State Governments. State governments, while providing a relatively small portion of total early-stage technology development funding, play a critical role in establishing regional environments that help bridge the gap from invention to innovation. State governments facilitate university-industry partnerships, leverage federal academic research funds by providing both general and targeted grants, build a technically educated workforce through support of public colleges and universities, and ease regulatory burdens to create a more fertile ground for technology startups. While Route 128 and Silicon Valley arose with little local- or state-level political support (in part because they had developed the needed networks, stimulated by defense funding, in the 1950s), a number of states have created many of the environmental features needed for successful innovation. Research Triangle Park in North Carolina, for example, was conceived and initiated by Governor Luther Hodges.

These geographical concentrations create additional challenges to champions of early-stage technology development projects located outside of favored geographical or market spaces. Such challenges may be of considerable importance to public policy. The implications for public policy will depend heavily on whether the federal government attempts to compensate for such tendencies toward concentration, or chooses instead to accept them as reflecting the flow of resources to geographical and market areas in which expected economic returns are highest. In subsequent work, we will further explore the causes and implications of inter-regional and inter-industry differences in funding for early-stage technology development projects.

Among corporations, the fraction of R&D spending that is dedicated to early-stage development varies both among firms and within industries. The latter variation may be related to industry lifecycles.

Support levels for ESTD vary widely by industry, and by company within specific industries. The Booz Allen & Hamilton team estimated (by extrapolation from reports from interviewed firms) overall corporate spending on early-stage technology development to be approximately $13 billion annually, or 9 percent of total corporate R&D spending. Spending was found to differ widely by industry, as well as by company within specific industries. For example, ESTD investments in the computer software industry is essentially zero, while for the biopharmaceutical industry, the rate is 13 percent. Software companies use existing technical tools to help expand functionality. These are not technical innovations, strictly speaking: even in the midst of the massive Internet boom (according to respondents in the Booz Allen & Hamilton survey), few true technical innovations emerged out of the computer services sector. Indeed not all of the investments Booz Allen & Hamilton reported in other industries are based on new science, nor are all of them outside of core business areas. Within the biopharmaceutical industry, ESTD spending ranged from 0 percent to 30 percent of R&D at the companies interviewed.

A key driver of ESTD support levels appears to be life-cycle position of the industry and the individual company. More mature industries, such as the automotive sector, tend to invest a smaller percentage of R&D into earlier stages such as ESTD than do industries at an earlier stage of evolution, such as biotechnology.

However, individual companies may make disproportionate investments in early-stage R&D compared to their peers in an attempt to break out of their existing positioning or to rejuvenate their innovation resource base. Several companies interviewed by Booz Allen & Hamilton described how they reached a deliberate decision to rebalance their investments toward ESTD and earlier stages after recognizing that they were not positioned for growth. In some cases they have managed complete transformations out of an historical line of business and into high-tech sectors in which they did not participate a decade ago. Monsanto’s move into genetics in the 1980s is a successful example of a company making a temporary movement backwards out of a product development focus and into a strategy emphasizing basic and ESTD research.

The distinction we draw between the speculative research most firms pursue to advance the performance of existing products and research on high-risk new technologies that lie outside the firm’s core business area (ESTD) is admittedly not a crisp one. It is much easier to identify ESTD investments by governments at state and federal levels, and to recognize university forays into new business ventures based on faculty research. In those cases the motivation of the investor is unambiguous. However, for public policy reasons, it is critically important to quantify the modest fraction of corporate R&D that is invested in new business areas outside the core. Some research does suggest that radical innovations are most likely to be successfully launched by new ventures formed with the specific objective of new product development, as opposed to large corporations. Yet in absolute terms the assets of established firms—their financial resources, skill and market experience—are substantially greater than those of other major sources of ESTD funding. Consequently, policies to encourage ESTD may be most effective when directed in part to encouraging successful out-of-core innovations by established firms.

CONCLUSION

As investors stampeded first into, then out of the public market for equity in technology-based firms, the assertion that U.S. economic growth is led by entrepreneurial, venture capital-backed firms became almost an article of faith among politicians, pundits, policy makers, and the general public. The number and diversity of institutions specialized in supporting the commercial development and marketing of new technologies have expanded dramatically—a trend unlikely to reverse itself.

Funds available to high-growth technology ventures appear at first glance to have grown accordingly. In particular, the overall growth in the size of the venture capital industry during the past decade suggests to many observers of the U.S. innovation system that private funding is available for high-technology projects. Yet, even in an environment where large sums committed to venture capital funds remain undisbursed, practitioners report that the process of translating a basic science invention into a commercially viable innovation is extremely difficult and getting more so.

The economic and technological factors driving this trend are not new. Markets, technologies, and their interrelation are becoming increasingly complex, further complicating the challenge of converting inventions into innovations. The rapid advance of the scientific frontier and the increasing breadth and depth of knowledge available across all scientific fields have contributed to the acceleration of technological complexity. Today, even the large corporations with the largest R&D budgets have difficulty putting together all the elements required for in-house development and commercialization of science-based technologies.

A core finding of this project is that the federal role in early-stage technology development is far more significant than may be suggested by aggregate R&D statistics. In general, we find that federal technology development funds complement, rather than substitute for, private funds.

National investment into the conversion of inventions into radically new goods and services, although small in absolute terms when compared to total industrial R&D, significantly affects long-term economic growth by converting the nation’s portfolio of science and engineering knowledge into innovations generating new markets and industries. Understanding development of technologies in the phase between invention and innovation is important because a national and global capacity to sustain long-term economic growth is important. Decisions made today regarding the nature and magnitude of federal support for early-stage technology development are likely to have an impact far into the future.