This month’s cover story comes in two parts, the goal being to allow the problem of innovation to be viewed from two perspectives: the intellectual challenge and the fiscal challenge. The intellectual challenge of innovation for managers lies in recognising that the signs of future growth are found in current strengths only in so far as the proof of the pudding is in the eating. By Leon Gettler
“Innovation” and “growth” are terms bandied around a lot these days. But although the words keep coming and those signposts keep popping up, the question remains: how is it that some companies grow and prosper and others do not, even under similar circumstances?
It is a conundrum that few can answer, and that makes it a big problem for any innovator wannabe. It is also an issue that goes to the heart of those institutional barriers in organisations that both protect and hinder. Left unchecked, these very human forces create an inherent bias against all that is new and creative.
A recent study from the London Business School suggests that for all the time and money invested in research and development, and for all the resources dedicated to finding points of difference with competitors, most businesses are erratic and irregular innovators.
The author, economics professor Paul Geroski, found that the path of innovation never runs true. It is more a random stroll than a linear walk. His research revealed that commercially successful breakthroughs and patents tend to be arbitrary, with a company typically innovating every once in a while, and long periods between successful developments. The result: unpredictable growth spurts. The corollary: the size of companies is a sometime thing.
The study, entitled “The growth of firms in theory and practice”, found little correlation with the overall economy. Many companies were not substantially affected by a downturn in the economy, and some actually thrived in hard times. Indeed, there was little evidence of common growth rates across businesses even in the same industry. Every company seemed to have its own particular history.
The most striking of Geroski’s findings was that innovation is erratic because companies do not like cannibalising previous investment, innovation and brand management.
A frequently cited example is Xerox. In the 1960s and 1970s, Xerox developed such computer tools as the mouse and the graphic user interface that allowed users to navigate their way through systems. Xerox decided not to put these on the market. Why? Because it was an office equipment maker, not a computer company.
Another example was the ill-fated “Star Trek” mission of Apple and Novell programmers in 1992. Working in premises opposite Intel’s headquarters in Santa Clara, California, the project was about grafting – or, in geek-speak, “porting” – the Macintosh operating system on to an Intel chip. The result: a prototype MacIntel machine, which was to have been the user-friendly alternative to clunky MS-DOS and Windows 3.1. This would have hit the stores a year before Windows 95.
But, then, something happened. The project’s chief backer was poached by the enemy and the Trekkies mission was aborted. The Apple board got restless and rolled the chief executive. End of story.
The self-consuming organisation
Economist Lester Thurow, in his book Creating Wealth, says: “Successful businesses must be willing to cannibalise themselves to save themselves. They must be willing to destroy the old while it is still successful if they wish to build the new before it is successful. If they won’t destroy themselves, others will destroy them.”
Well, that’s the theory. But saving yourself by blowing yourself up is not for everyone. Maybe that is why General Electric, a re-invention specialist, was one of the most successful corporations at the end of the 19th century and was still there at the end of the 20th. But that’s GE.
Geroski’s study found that growth patterns are generated by unexpected changes that leave a permanent mark on the business. Even if those shocks to the system are anticipated, not everyone has the capacity or know-how to prepare for them. Indeed, Geroski says, the overwhelming evidence suggests that the reverse is true: most organisations do not seem to be ready and are caught off-guard.
So, when the going gets tough, organisations tend not to make even partial adjustments to their employment or investment patterns. This is because businesses face fixed costs. They do not respond to a problem until things get so bad that the organisation has to do something.
In other words, an organisation needs to reach some threshold of poor performance before it springs into action. In the lead-up to this, it tolerates a little deterioration in performance, just to make sure the shocks are important enough to warrant some sort of rescue operation and innovation. And, when that happens, the organisation moves into attack, focusing all its efforts on one big hit. This results in large but infrequent and discrete changes in the operations of many businesses. They don’t do it often; but, when it is done, it is done with a big bang.
If Geroski is right, it might explain why nothing has changed since the early 1990s when Australia resolved to become the “clever country”. A market dominated by oligopolies and multinationals with large fixed costs tends to work against the development of an innovative business culture. In the case of the multinationals, they have the biggest share of sales but generate only a small proportion of exports. The implication is that overseas giants see Australia as little more than a target market.
The patently obvious
Another problem here is that Australian industry is structured around mechanical devices and natural resources. An alarming report from CSIRO and the Australian Research Council suggests that this could hinder innovative processes. The report reveals that Australia’s performance in research-based technology, compared with the rest of the world, has been mediocre, to say the least.
The study, “Inventing our future”, shows that, over the past 18 years, in the United States system – in which, if you have patented an idea, it cannot be copied anywhere else in the world, at least in theory – Australian patents have risen from 0.45% to just 0.5%.
In 1980, Australian inventors had many more patents in the market than their counterparts in Israel, Taiwan and Finland. Cut to 1998, and Israel has pulled ahead. Finland has nearly caught up and Taiwan is the fourth most active of the 11 countries analysed, with 3110 patents; mostly in semiconductors and electronics, textiles and apparel, and electrical appliances.
By way of contrast, Australia had just 755 patents. The report said the biggest gaps were in computers and peripherals (for instance, hard drives, image-scanning devices and printers), telecommunications, semiconductors and electronics.
Patents are critical because capitalism is predicated on establishing clear guidelines on who owns what, and it is those guidelines that determine to what extent you can appropriate the output from those assets and make a buck.
In a knowledge economy, patents are more important than they would be in one in which success depended on natural resources and capital. This explains why 161,000 patents were issued in the US in 1999, nearly double the number of a decade earlier.
The issue of who owns what is particularly important in the “new economy” because the old barriers to entry have become less significant. Labor is mobile, capital is cheap and more readily available, and first-mover advantage can be as transient as brand recognition.
The most fascinating trend is that patents have shifted towards methods and processes as organisations realise that being innovative is not just about building better widgets.
The pioneer in this area was Dell Computer, which put in patent applications in the mid-1990s for its innovative and distinctive build-to-order method of business. It did this just as computers became commodities.
Companies such as Walker Digital in the US make money by producing nothing but patents; among them, the reverse auction, in which the consumer nominates a price and suppliers move to meet it. The company’s owner, Jay Walker, is taking legal action against Bill Gates. He claims Microsoft’s Expedia site infringes his reverse-auction patent. Similarly, Amazon is going after Barnes & Noble. It claims Barnes & Noble’s Express Lane infringes Amazon’s one-click shopping patent.
Such is the momentum to patent methods of doing business that even financial services companies are getting in on the act. According to one estimate, Merrill Lynch has 16 patents and Citigroup 14.
This is the issue at the heart of the Microsoft anti-trust case and the recent US Federal Court order to close Napster, the awesomely successful music-sharing internet service.
It prompts a number of questions. Who owns the ideas in a knowledge economy underpinned by ideas? Should there be controls on the flow of information when the power of the internet lies in its capacity to break down national borders, open minds and zip information around free of charge? When exclusive property rights in the form of patents are awarded in areas like seeds and genetic engineering, isn’t there a danger there that we will be left more shackled than the time when the internet was used just by the military?
The trouble is, patents have also become barriers to entry; and patent suits are now being used as strategic weapons to create delays for competitors. And, because creativity can feed off itself, with one development inspiring another, there is a risk that over-zealous legal enforcement will stymie innovation.
This is why Jeff Bezos, the founder of Amazon, now argues that software and business-method patents should have a shorter life than other patents.
The Web is also challenging innovators and regulators through the growth of the business-to-business (B2B) internet marketplace, particularly in the area of procurement. Supply-chain management has never been the stuff to excite passions, but the new business models of buying consortiums may have profound implications for innovation.
B2B can be defined as a network that connects buyers and sellers over the internet, and often involves a third party who organises and manages the forum, for which it charges a transaction fee. B2B transactions are expected to take over from business-to-consumer (B2C) commerce as the main game. An ActiveMedia Research report says B2B represented 18% of online commerce in 1999 but, by 2005, it will be half of all business on the internet.
In Australia, Amcor, AMP, ANZ Banking Group, Australia Post, BHP, Coca-Cola Amatil, Coles Myer, Fosters Brewing Group, Goodman Fielder, Orica, Pacific Dunlop, Qantas, Telstra and Wesfarmers have established corProcure, an online system to handle the purchasing of telecommunications, computer services, office supplies, fuel, insurance, legal services and other items. A case of the old adage “strength in numbers”, the exercise aims at reducing total costs through volume purchases.
Another advantage is that it can break potential bottlenecks by opening up many more supply options. It can attract new suppliers to the market, and it can also work the other way when the consortiums can jointly develop new sources of supply or infrastructure that the individual members might find too costly to do on their own.
These models echo the old-style co-operatives in which traders came together to maximise their buying power and minimise risk. The Dutch East India Company, established in 1602 when Dutch merchants decided to set aside their quarrels and establish a commercial structure as a united front to foreign competition, and a vehicle to defray risk, was a prime example of this sort of thinking.
Of course, what is different in these exchanges is the connectivity. It can produce extensive cost savings and new revenue opportunities, particularly if the participants get a slice of the transactions. The online automotive-parts exchange announced by General Motors, Ford Motor Co, and DaimlerChrysler, for example, is expected to collect $US3 billion in annual revenue from transaction fees, advertising and services.
To b2b or not to b2b
This presents two challenges for innovation. First, industry-wide B2B exchanges not only identify best buys and cut component prices. They can also freeze out new market entrants and allow a few big buyers to gang up on suppliers. The effective exchanges will encourage innovation, particularly if it is outsourced to suppliers. But the potential for homogeneity is also there, which could militate against the development of innovative business methods.
It is significant that the B2B phenomenon has attracted the attention of regulators. The European Commission, for instance, is preparing an anti-trust ruling on MyAircraft.com, a B2B joint venture selling aircraft spare parts and engines, set up by Honeywell International, United Technologies and i2 Technologies. In Australia, the local regulator is keeping an eye on corProcure.
A related issue is that, with exchanges, margins are typically sacrificed for volume. At the same time, the life cycle and point-of-difference of the products moving through the chain will be reduced. Any computer supplier will say that today’s hottest product is tomorrow’s commodity. There is nothing new in that. What is different here is that it will happen a lot faster if it is passed through an exchange of players who may not perceive a competitive advantage in those products representing a core competency.
This does not spell the end of innovation by any means. But it does change the game, as companies decide which activities should be outsourced and which kept in-house. More activities, like research and development, production and even customer contact, are likely to be outsourced, and there will be more manufacturers that do not work from factories.
The challenge for companies is to develop a better understanding of what value they add. This is not as easy as it sounds, particularly in the light of Geroski’s findings on organisational inertia. The problem with knowing where you add value is like the one about core competencies: it’s a lot easier to identify what you don’t do than what you do do.
None the less, globalisation and technology offer opportunities for smaller participants to innovate through networks and link with larger organisations. For instance, the Melbourne-based private outfit Lochard, which specialises in the design and building of airport management systems, has formed links with organisations like Dutch National Aerospace Laboratories, CSIRO, Swinburne University, Thomson-CSF Research Laboratory and Wylie Laboratory. Biota employs only 20 people but it has strong links with research organisations across Australia and has struck deals with foreign pharmaceutical companies, including Glaxo-Wellcome, for marketing and distribution.
It is not only the external networks that are critical. Truly innovative companies are committed to getting advice from all parts of the organisation and keeping up with the flow of new products and innovations. One of the most crucial ways of doing this is by rewarding and training employees in different areas in the organisation, from business skills to personal development. Another is subverting what has already been created. The trick is to identify what is worth preserving.
In strength is weakness
Australia’s strong culture of management capitalism may be an incidental obstruction to innovation as it encourages a sort of collusion for the best between financial and corporate managers
by David James
In strengths often lie weaknesses. Australia’s financial structure, which has served the country well through most of the industrial period, may be a cause of the country’s failure to develop an innovative industry culture. Australia is one of the world’s oldest and best examples of “managerial capitalism”: a financial system in which coincide large-scale, independent savings institutions (insurance and superannuation companies and the like), and large corporations run by professional managers who do not have large-scale ownership of the companies they oversee.
Having savings institutions separate from government and employers underpins long-term economic stability (a point just beginning to be understood in Asia, Latin America and Europe). One reason is a far better distribution of wealth. In Australia, the largest capital bloc is in the Queensland Public Sector Superannuation Board ($6.5 billion), followed by Kerry Packer ($6 billion). There are 10 more pension funds before we get to the next individual: Frank Lowy. These include other public-sector pension funds and the superannuation capital of large companies like Telstra and Qantas. It is estimated that the capital in Australian superannuation will be more than $1 trillion by 2002.
A similar breakdown of wealth in most Asian and Latin American countries would reveal a much higher proportion of wealth in the hands of individuals. Equally, the managers of large companies would tend to be their owners, or relatives of their owners.
To those committed to a fairer society, this indicates a general superiority in the Australian system. The problem is, the characteristics that lend themselves to institutional stability also militate against developing an innovative culture. Because the capital is mostly in the hands of fund managers, and the companies are mostly overseen by managers, there is an implicit agreement between the two parties, neither of whom own what they control, that managerial processes – as applied to investment practices and to company operations – are the source of wealth creation.
At one level, this is unarguable: successful entrepreneurs say that execution is everything. Having a disciplined approach to managing risk and reward is also incontestably the basis of sound investment practice.
The problems arise when it becomes necessary to change processes, the kind of seminal changes that are occurring as developed economies move into the post-industrial “knowledge economy”. Managers are likely to be more reluctant to change successful investment or business practices than entrepreneurs, whose orientation is towards the new. Managers are also less likely to embrace the unique and the surprising because, by definition, they will not fall within existing processes. Innovation is entirely concerned with the new and the surprising.
The collusion between Australia’s financial and corporate managers is exemplified by dividend imputation (franking): the making of dividends tax free in the hands of shareholders to the extent that the company has paid Australian company tax. At first sight, this seems a laudatory removal of a hidden form of double taxation. If a company has paid company tax, why should a shareholder also pay income tax on dividends?
But what has happened in reality is that the managers of Australia’s corporations have had an incentive to be risk-averse. Rather than using profits to invest in research and development, or innovative practices, they have, whenever possible, recycled profits back to shareholders; or, more accurately, to fund managers in the financial institutions.
This, in turn, has allowed fund managers to adopt a low-risk, high-income policy in the sharemarket. Rather than investing in high-risk, innovative companies, they have been able to ensure sound sharemarket returns from high dividend-paying corporations. As long as the share price of these companies improves incrementally, the combination of the capital gain and the dividend is enough for them to achieve adequate returns. “Franking has made Australia’s corporations extremely risk-averse,” says Alan Carroll, chief executive of the consultancy Carroll Partners International.
As a consequence, few companies in the Australian market have been able to achieve big increases in their share price, even though the overall returns from the market have been sound. By reducing the need to invest in companies with capital gains (share-price rises), the Australian investment community has implicitly been biased against innovation.
A comparison with the United States market demonstrates the point. In 1987, the Australian All Ordinaries Index reached 2900, and it is just over 3200 at the time of writing. Before the 1987 crash, the US Dow Jones Index was a little over 3000; now it is comfortably over 10,000. The message is clear: the managers in charge of Australia’s industrial development have failed to identify and invest in the new, innovative economy. Instead, they have supported the largely defensive, cost-cutting strategies of Australia’s oligopolistic corporations.
Of course, there is no sense in which any individual can be held accountable for this state of affairs; it is a systemic issue. But there is little doubt that the capital gains available in the new economy have been missed in Australia because of a high level of conservatism in relation to innovation.
Another reason for Australia’s poor response to innovation may simply be cultural. Peter Farrell is chairman and chief executive of ResMed, a $1.5-billion sleep-equipment company that was “born global”. ResMed began in Australia but is now listed on the New York Exchange and sells in 50 countries.
A former academic, Farrell is critical of the attitude in Australian universities to commerce. He says universities in the US have mature links with industry, but Australia’s academe does not.
“We were never able to deal successfully with CSIRO because it automatically assumes commerce is bad,” Farrell says. “I think it comes from the British disease: if you are in manufacturing or commerce, you are probably a scumbag and not pure. You know, there is this terrible thing called money. Well, the fact is that, if there is no wealth creation, you cannot have an equitable society because there is no pie to cut up.”
Farrell has no illusion that Britain is a great nation: in industrial terms, it has been a great squanderer of ideas. “ICI was started by a couple of German chemists. A lot of industry was from the Midlands and the North. They wanted to send their kids to Oxford and Cambridge so they would get pukka accents and join the crowd that knew nothing about technology even though technology was the turbo-charger of the future.
“Britain lost so many opportunities: it developed the jet engine, the hydrofoil. Yet Japan, which had relatively few ideas, implemented them because they knew that the number-one thing in business is execution. If you don’t execute, there is no business; and the Brits are terrible at that.
“In Australia, we picked up the British disease: CSIRO is academics who don’t have a clue about business. They have a linear view of innovation: throw money at the problem. Get all these bright people in the room and they will come up with ideas that industry can take and make nice products out of.
“How can you have four or five people working on the human genome: what is that going to do? You have got to target areas, but they are working on every area known to man. It’s nuts. It is called the Commonwealth Scientific and Industrial Research Organisation, but it is still not doing enough industrial research. Its complaint is that there are not enough smart people in industry; well, go join them.
“Unless you get industry involved at the start to set the goals based on what companies believe the market needs, it is never going to happen. Look at holography. It won the Nobel Prize in 1948, but where are the marvellous businesses? It is on a few credit cards and US green cards. Compare it with the transistor, which also was the Nobel Prize winner in 1948.”
Signs of stirring in government and the management community are starting to appear. Some of the most important impediments to a focus on capital gains have been removed. To the extent that a greater interest in capital gains converts to a greater interest in innovation, this seems promising.
In consequence of the Ralph report on business taxation, three vital impediments to more dynamic capital markets have been removed, or are in the process of being removed. First is a reduction on local capital-gains tax, which greatly increases the attractiveness of non-defensive sharemarket investments.
Second is the removal of tax on scrip-to-scrip transfers. This was a punishing disincentive for start-up companies in Australia. The much-vaunted Silicon Valley entrepreneurial model is based on an extremely high-risk, high-return financial structure. The entrepreneurs will often work for next to nothing in the hope that they will be able to convert their stock options into spectacular wealth when they sell their fledgling companies to a large US pension fund or mid-level mezzanine capitalist. They are hardly likely to take the risk if they are heavily taxed at the point that they convert their creations into wealth.
Farrell says: “If you are a proper venture-capital fund you expect one in five of these investments to pan out. If you are doing one in five, you are doing well. To be able to spend that amount of money, you have to get hundreds-of-percent returns on the ones that win. But you aren’t going to do that if you have to pay income tax at marginal tax rates.”
The third big change is the policy on overseas investment. This is perhaps the most dramatic change of all. It was, in part, modelled on the experience of Israel, which sparked a “new economy” boom by in effect inviting in US pension funds. Foreign institutions investing in local innovative companies are required to pay tax only at the level they would pay in their home economies, meaning that there would be no penalty in coming to Australia. There is significant disagreement about what investment thresholds should apply to this policy, but the general direction is highly positive.
There are also indications that Australia’s financial institutions are beginning to take venture capital seriously; about a decade too late, but better late than never. Australia will never have the diversity and depth of the US capital markets, in which there are large pools of philanthropic capital, aggressive private capital, and long-term venture capital (in addition to the managed capital of the pension funds). But there is hope of a more “offensive” orientation in the financial-management community. The union-based Industry Funds Services group has begun to look seriously at the investment class. The Australian Venture Capital Association (AVCAL) is reporting much higher levels of interest, although much of this is not strictly venture capital, but mezzanine (mid-stage) investment.
What has not yet appeared is widespread evidence of a more aggressive approach from Australia’s large corporations or the foreign corporations that dominate Australia’s industry base. The suspicion is that the large-scale changes to innovation in Australia are yet to occur. A report by the New South Wales-based Warren Centre for Advanced Engineering, compiled by consultant Howard Gwynne, found that many participants in the recent Federal Government-sponsored Innovation Summit are sceptical that the necessary institutional changes will occur.
The report says most would-be innovators in Australia believe that the current system works against them. “The traditional drivers in our economic system – government and large organisations – do not appear to be interested in innovation. Financial systems do not work for innovation. Business structures such as law, accounting, government regulations and investment rules are not innovation-friendly. Academic and R&D traditions support R&D as an end in itself but do not encourage follow-through to commercialisation or practical application. Industry and discipline territorialism has produced fragmentation of professions and knowledge.”
Farrell is more blunt. “Australia’s approach is so far out to lunch it isn’t funny. What you need to do is set up the socio-economic environment in which wealth creation can take place, and we are not there yet. There was a huge step forward with the capital gains tax change. But we need much more money going into university R&D work and much more application-oriented university R&D funding that forces them into the market place.”
Farrell believes that there are many positive signs, but he holds out little hope that Australian Governments will be able to lead the changes. “Take the Innovation Summit. They get the wrong people at these things: the professor of Pot Plants advising the Government. It’s just a talk-fest. But they don’t actually expect anything to come out of it; it is just humoring people. How much work do you think they do on it? It is just going through the motions.”