The Financing of Innovation

A theoretical overview with case study

Abstract

Financing innovation is becoming an important issue both in the finance and in the technological field. The high risks involved in the launching of a new idea and the amount of skills required to make it successful need a new kind of financing that traditional investment methods cannot guarantee. The aim of this paper is presenting the main issues and solutions recently developed, with an emphasis on Venture Capitalists and crowdfunding. A real-world case is also presented to provide a quantitative aspect of the topic. In particular Kickstarter has been chosen, since it is one of the most renown crowdfunding platforms and the reader may have the occasion of actually using it, hence becoming part of innovation itself.

Theoretical Perspective

According to the Merriam Webster dictionary, innovation is defined as

"The act or process of introducing new ideas, devices or methods"

This definition specifies the key difference between innovation and invention, which is not the creation of something new, but rather the real-world implementation of an invention.
This critical difference makes that, while inventions can happen in a garage, innovation cannot. Introducing a new product, may it be an idea, a device or a method, into an existing market requires considering a multiplicity of aspects that go far beyond the technical issues.
Of all these aspect, the most critical one is money. The current markets are all money-centric, and thus whenever there is an interest in getting into one, the economic side must be carefully considered.

The first economic problem an innovator may encounter, is how to finance his idea to make it successful. Most often, people who invent are technical experts, but lack a proper knowledge of business or economics. On the other hand, investors are usually focused on money. They have a deep knowledge of market and finance, but are not particularly interests in technologies itself.
There is then, an obvious problem of communication. The inventor needs to show how his new idea can solve a real-world problem and the investor must understand how the proposed idea can fit in the market.

This gap in vision becomes even more wide when the inventor has not invented anything yet. This is the common case of Research and Development departments in companies.
R&Ds have the arduous task of creating new products or processes that will help the company in some ways. As such they require investments without guaranteed payback and mostly without any clear idea of what the final product will be.

The undefined nature of R&D projects makes such investments exceptionally risky. Consequently, sources of funding differ from the ones of typical business investment on tangible assets. A recent survey on Italian manufacturing companies shows that about 80% of finances invested in R&D come from the cashflow of the company itself. This is in contrast with typical investments where only 50% of the founding comes from the company and long term debts have a more significant role.

Such high incidence of cashflow is not well compatible with the ideal for R&D. The innovation department usually requires steady investments over many years. Cashflow provides the opposite. Money movements of the company can be subject to great variations along the years, consequently the amount invested can fluctuate a lot. Negative prediction of future cashflow may also reduce mid-term investments such as R&D.

On the other hand, long term debts are not suited for R&D from the investor point of view. The undefined results expected, the little information shared by researchers for fear of expropriation of knowledge, and the absence of tangible assets on which to secure loans, makes such investments blind. Consequently, the usual sources of long term debts, such as banks, tend to refuse investing in such high-risk projects.

All these issues are magnified in the case of start-ups. R&D departments are greatly helped in that they are one department in a wider company with some level of steady income and a define target market. This is not true for start-ups, where the only defined point is an idea and there is no steady income yet.
In particular, start-ups cannot be financed with cash-flow, since there usually isn’t one, and have the same problems of R&D regarding long term investments.

Consequently, there it seems to be a gap in the market of investors for small newly born innovative companies. In recent years, a new figure has emerged to fill the gap, the Venture Capitalist. Venture capitalists invest in small hi-tech companies by means of purchase of shares until the company has reached a sufficient value to be sold on the market or to a corporation. Venture Capitalists usually help the start-up to transform from a team with an idea to a real company. In fact, they do not only provide the money, but most often give strategic advice and help the company in finding a place in the market.

This approach to investment is very risky for the VC, but when successful can provide returns equals to many times the value invested. As such the key talent of a Venture Capitalist is choosing the right start-up to invest in. The process for selecting the right company is consequently long and complicated. More in resemblance with sport, it starts by scouting for new companies with potentiality, rather than waiting for start-ups to come to them. The selection process then involves the analysis of their market proposal and business plan, a meeting with the team to evaluate motivation and skills, and finally an overall assessment of the enclosed potentiality.

Venture Capitalists have proven to be an excellent way for new company to launch themselves, but they are not the only one.
With the spread of Internet new paradigms for financing innovation have been developed, and one of the most successful has been crowdfunding. Crowdfunding is a method of raising money from many people in exchange for products or services rather than money. Although limited in some ways with respect to venture capitalists, crowdfunding has now raised more than $34 billion to fund over a million projects, making it an important player in the field.

Contemporary Case

On April 28th, 2009 Perry Chen, Yancey Strickler and Charles Adler launched Kickstarter.
Kickstarter allows user to privately finance small projects proposed by other users, effectively becoming one of the first crowdfunding platforms available globally.

Through the sole use of the platform, makers can propose their own projects and choose a deadline and a minimum funding target. Users are then allowed to support the project at their own discretion. Support is usually rewarded with a discount on the final product or experience and different rewards are available depending on the amount given. Since there is no proper contract between investor and creator, Kickstarter does not instantiate any payment unless the target is met within the deadline. This is meant to work as a sort of guarantee, even though there is no assurance that the final product will be delivered even in case the goal is met.
The lack of proper investments bureaucracy makes that each user is fully responsible of his own choices and makers must provide valid ideas and proper rewards to get the funding.

Kickstarter revenues comes from small fees on every successful funding. Consequently, it is not directly involved in the funding of any project and, above all, does not claim any ownership on projects or products funded using the platform. This is a key aspect that helped Kickstarter rise against competitors.

Being innovative in its own right, Kickstarter mainly focuses on innovative and creative projects.
In particular, any project must belong to one of 13 categories: Art, Comics, Dance, Design, Fashion, Film and Video, Food, Games, Music, Photography, Publishing, Technology and Theater. Noticeably, charity and awareness campaigns are missing, since Kickstarter pushes towards innovation rather than social issues per se.

Moreover, for all those projects involving a tangible result, feasibility is often not guaranteed. To address this issues Kickstarter obliges all the “hardware” projects to include a physical prototype and a manufacturing plan, as well as forbidding the use of photorealistic simulation.

Theory analysis in the contemporary case

Reaching back to the beginning of this paper, one may argue that Kickstarter is a tool for financing inventions rather than innovation. Such argument is appropriate, as a stunning 40% of the successfully funded project sits in the Music and Film & Video category, where the result usually is a media products which lacks the proper novelty required by innovation.

However, there are some technological products which managed to evolve from invention to innovation. Main example of this is Bragi Dash.
Bragi Dash are wireless smart headphones that fit in-ear and provide multiple functions such as playing music and counting steps.

Launched on Kickstarter in 2014, it received $3.4 million of funds with more than 20’000 backers.
Such numbers make Bragi to become more than an invention, effectively placing it at the second stage of the innovation adoption chain: early adopters. From Kickstarter Bragi was able to start a successful business with more than 30 patents and expected revenues of $100 million.

Overall Kickstarter is a good example of an innovative way to invest in innovation.
The key difference with respect to traditional investment methods is its inherently social nature, which makes that the successful projects have already reached a rather big audience before being effectively launched on the market.

On the other hand, crowdfunding most often is not enough to properly fulfill an innovation process. Going back to Kickstarter statistics, we find that more than 50% of the successful projects sit in the $1’000 - $10’000 funding range, which is just enough to get a project started but cannot satisfy the necessities of a serious business undertaking.
Moreover, crowdfunding only provides economic support and cannot help the innovator in developing a proper business model and acquire the necessary knowledge required to become an entrepreneur.

Consequently, not all the successful projects manage to become successful companies. A clear example is the Coolest Cooler, a multi-function refrigerator that became the second most successful project on Kickstarter with more than $13 million raised.

Although it received far more than the requested funds, the people behind the Coolest Cooler were not able to set up a proper production plan and failed to start a successful business. In fact, the Coolest Cooler is now available on Amazon in the attempt to finance delivery to the original investors, the backers.

Investing in innovation then has to do with far more than just money. Business skills and market knowledge are just one of the many resources required by an innovator.
Crowdfunding, nevertheless, helps ideas become reality and thus it can be a tool for innovation.

May 27th, 2017

Milano

References

https://www.merriam-webster.com/dictionary/innovation
https://www.kickstarter.com/help/stats
https://www.forbes.com/sites/amyfeldman/2016/04/14/ten-of-the-most-successful-companies-built-on-kickstarter/#5d3a650a69e8
https://www.forbes.com/sites/chancebarnett/2015/06/09/trends-show-crowdfunding-to-surpass-vc-in-2016/#45476b8c4547
http://bgr.com/2016/04/15/kickstarter-coolest-cooler-fail/

Note: The paper was developed as homework for the course Dynamics of Innovation held by professor Cantamessa at Alta Scuola Politecnica