Our post and press release on how accounting kills innovation has generated some really nice debate. Although I had a lot of criticism from my academic colleagues in accounting and finance, most of that was from people who hadn’t actually read the research paper. One of the biggest objections was that innovation academics like me should stay out of finance because it’s not my discipline. Obviously, this got me pretty fired up and I started thinking about why I got interested in the valuation and selection of innovation projects in the first place.
About five years ago I was in discussions with a firm to create a joint-venture research project on open innovation. After developing the proposal, the project was taken to the directors of the business and the subsequent phone conversation went a little bit like this….
Them: Well, this is a really nice project that relates to a very important part of our business but can you tell us how much the project will return in dollar terms?
Me: This is a research project and we don’t know what the outcomes will be. There is a chance that it might create a completely new stream of business for you but there is also a chance that we will not find anything of immediate value.
Them: Yes, we understand that it’s a research project…. but how much is it worth?
There was more to the discussion, and we cycled around this conversation for some time but it was pretty clear that it was going nowhere. The company’s executive were interested in solid and immediate returns and a long-term project with outcomes ranging from nothing to potential business transformation just didn’t fit into their framework.
While valuation methods are part of the problem, the biggest issue is the tyranny of short-term thinking. The future is always heavily discounted. Even though we know that innovation gives payoffs in the long term (as someone said recently, the net present value of innovation is survival) the attraction of not making long term investments in order to improve current returns is too great. A recent survey of 400 CFOs in US public and private firms showed that an amazing 78% admit to sacrificing long-term value to maintain short-term predictability in earnings and financial disclosures (Graham et al. 2005).
Short-termism pervades our psychology and our institutions, which means that we are swimming against the tide when we try to create an environment that supports innovation. We focus on what we know and we extrapolate from the past. The result of this is that we start to believe that the short term is also the long term. I have seen classes of MBA students who are genuinely shocked to learn that only two of the top 100 US firms in 1900 are still around today and only about 1% of firms are able to sustain competitive advantage over their peers for periods of 20 years or more.
I think the best way to fight short-termism is with evidence and here we have three big weapons at our disposal.
1. The growing evidence from behavioral economics about how psychology affects decision making. A Nobel prize has been won for this research and if we know what the biases are that make us short-term thinkers then we need to be vigilant against our own biases. This area is now being taken very seriously by major consulting firms.
2. Consistent evidence that the price of not innovating and adapting is death. I wrote a post about this a while ago, but as the Jack Welch quote goes, “if change is happening on the outside faster than the inside, the end is in sight.”
3. We know a lot about effective innovation processes that build value over the short, medium and long-term. Lots of really great things have been written and there is an accumulation of evidence that points to the value of having a portfolio of innovation activities, managing innovation as a process and valuing innovation projects differently. The short-termist’s excuse that innovation can’t be managed just isn’t true. Leading firms disprove this every day.
I don’t think we are ever going to win the fight against short-termism. It’s just too deeply embedded in our psychology. However, the cost of not taking up the fight is great. Our collective futures are at stake.
Source: “The Economic Implications of Corporate Financial Reporting,” John Graham, Campbell Harvey, and Shivaram Rajgopal, Journal of Accounting and Economics, 2005, 40: 3-73 (Thanks to Mat Hayward for telling me about this study).