R&D Subsidies do not create wealth. How do we modernize policy to incent innovation?

New contributor Ron Shuttleworth of Razor Capital Partners laments the persistent and chronic underfunding of Canadian ideas and wonders how the Canadian Government can shift policies to facilitate innovation.

I have spoken to hundreds of Canadian entrepreneurs and investors in the tech sector over the past dozen years. A common lament among all stakeholders is that Canadians are good at R&D, but poor at commercialization.

Based on current thinking, this is a decidedly bad thing, becoming worse.

What actually sparked this blog post has been the frustration of seeing really good ideas suffer from persistent and chronic underfunding. The result of which is truncated or even abandoned commercialization of ideas that may have been major successes if funded and supported elsewhere. How many RIMs have been left behind because entrepreneurs could not attract appropriate growth capital? How many entrepreneurs have simply left the country? How many great technologies have been sold before maturity for minimal shareholder return? Exiting this recession, it is an increasingly popular notion that future wealth creation will be generated though innovation…bringing ideas to life. Not production. Not resources.

How are we doing as innovators, and is it even important?

Because wealth creation is increasingly correlated to the presence of innovation in local economies, it now has its own worldwide ranking called the Global Innovations Index (GII).

When the GII was first published in 2003, the Canadian economy ranked 9th in the world out of 82 countries. The 2009 publication ranks Canada 14th, with a projection to 15th before 2013. Canada is included in a cluster of “Second-tier Innovators”. Top-ten or First-tier Innovators include the US (8th but dropping), and also Japan (1), South Korea, Singapore, Finland, Ireland and Sweden among others. The Global Innovation Index tends to favor smaller, highly urban countries with a large “creative class” of idea generators. Does this sound familiar? It should. Canada is over 80% urban with hub cities such as Vancouver, Toronto, and Montreal possessing “creative class” populations in excess of 30% of the total population. This ratio is among the highest in the world. And this does not include technology clusters such as Kitchener-Waterloo or Ottawa where the ratios are likely higher. Why are countries like Singapore, South Korea, China, and Finland racing up the charts while, despite the ingredients for success, we stagnate as Second-Tier Innovators?

It’s not that policy makers at all levels of government are ignoring the issue. On the contrary. There are a myriad of tax incentives (e.g. IRAP, SR&ED), grants, loans, and direct applied science through the National Research Council, and a multitude of Provincial programs. Almost all of these initiatives are focused on Research & Development. For nearly two decades, policy makers have held true that R&D creates innovation. Many now believe this to be wrong. Although R&D contributes to the process, commercialization actually creates innovation. So how does the Canadian Government shift policies to facilitate innovation?

First. What is an innovation?

At least one of the following five:
1. A new good or a new quality of a good.
2. A new method of production.
3. Opening a new market.
4. A new source of supply.
5. New organization of an industry.

R&D on its own, in isolation, as it is currently funded cannot deliver ANY of those five outcomes. R&D is usually a task within the implementation period of an innovation process, which is defined as:

Conceptualization -> Implementation -> Marketing

Despite the myths, innovation usually does not sprout out of thin air. Consistent and persistent innovation requires an infrastructure or ecosystem.

Access to Knowledge -> Local Adaption -> Financial Incentives.

It is within the innovation infrastructure where policy makers may be able to make some tweaks in order to better support the “creative class” and to help facilitate the commercialization of ideas. The primary problem with the Canadian market is that capital is becoming less available for innovation.

Re-Incent Venture Capital: Both private institutional and Labour Sponsored Venture Capital Corporations (LSVCC) are available to entrepreneurs for commercialization and this has been the primary engine of innovation since the 1980s. However the VC sector is not working as well now as it has in the past because a smaller percentage of available funds are actually invested, and the pool itself is drying up. Relative to VCs elsewhere in the world, there is an unusually large overhang of uninvested capital in the Canadian sector because VCs here may be incented towards risk aversion. As well, rules regarding investment criteria and tax incentives have not been updated for 20 years, making LSVCCs unattractive to the retail investors that they were designed for, relative to recent investment innovations that are more liquid. Policy makers need to update tax rules to facilitate more VC activity, attract more capital, and support higher tax-adjusted returns relative to other newer investment instruments.

Better Enable Public Venture: As VC funding has declined since the tech bubble, more entrepreneurs have taken the public route to commercialization via the Toronto Venture Exchange. Currently, there are over 200 early stage technology companies listed on the TSXV that have become listed through Capital Pool Corporation (CPC) mergers. However, there are only a handful of Canadian institutions that regularly invest in venture technology companies, and that number has declined with liquidity. The single biggest adjustment that can be made in the public markets is to offer flow-through shares for venture technology stocks. Currently, investors can benefit directly from mineral exploration tax incentives with flow-through shares. Considering that mineral exploration and technical innovations carry similar risks, and innovation is a potentially greater wealth creator, a class of flow-through shares should be created for publicly-listed technology companies that can benefit from tax incentives.

Modernize Direct Tax Incentives: A research report in 2005 from Booz Allen Hamilton suggests that R&D spending does not necessarily result in more innovation or performance from by an individual company. In fact, when R&D is effective, it often only benefits gross margin. The key to performance is cross department collaboration and effective innovation processes in the context of a scalable business model. Without a business model and processes, R&D alone is ineffective. Right now government agencies continue to focus tax incentives on the least effective activity in the context of commercialization and performance. Modernizing tax incentives to better encompass commercialization, while reducing administrative burden may help to promote more effective innovation, and ultimately, wealth creation.

Knowledge Clustering: K-W, or the Golden Triangle is the best example of knowledge clustering related to computer engineering and the University of Waterloo (and more recently Wilfrid Laurier University). Home grown VCs like Waterloo Tech Ventures, and an active mentoring community through Communitech have also helped to spawn some of the most innovative and successful technology companies in Canada (RIM, Open Text, Descartes Systems, MKS among others). Communities can adjust local tax jurisdictions to help promote knowledge clusters in other industries such as measurement devices, and biotech.

Education: There is probably a bigger issue in the development of finance, business management, and organizational management capabilities focused on technology and innovation. A new generation of people need skills to help to pump out more valuable intellectual capital going forward. Again, policymakers may look at grants and loan incentives to help bring more capability online.

These options discussed are only but a few, and they may not be practical. There are probably many more ideas. It would be interesting to see what others think about this issue.

Disclosure: I own shares of DSG.

About Ron:

With 20 years of experience in software, payment systems, and capital markets, Ron is President, RES Group Inc, a strategic consulting firm for business development, commercialization, and financing for small-cap and early stage technology companies. For the previous five years, Ron was an equity analyst for the Canadian technology space and covered small-cap companies that represented approximately $250 million worth of various structured financings. The basket of equities that were under coverage returned, on average, 35% to investors on invested capital.

Check out Ron’s entertaining and informative blog here:

http://resfreethinking.blogspot.com/

About Razor Partners:

Razor Capital Partners is a privately held advisory firm comprised of experienced ICPM licensed fund managers, investment bankers and entrepreneurs. For technology enabled public and private companies, Razor Capital Partners:

· Advises on mergers, acquisitions, and divestitures

· Provides strategic guidance and operational advisory services

· Sources capital through established distribution networks

· Provides direct access to capital

The firm specializes in information technology, new media, and cleantech sectors with an emphasis on market consolidation.