Is M&A a Real Proxy for R&D?
Companies often pride themselves on increasing their research and development (R&D) budgets, but we seldom hear about how the capital is allocated and the results of those investments. Blindly throwing money on pet R&D projects does not necessarily result in innovation or enhancements to a company’s product portfolio.
We often hear CEOs justify using mergers-and-acquisition (M&A) dollars as a substitute for organic growth by saying it is a proxy for R&D. It’s a catchy phrase to use during an investor call, and for the most part, people get it. It is a simple growth model, and many large industrial companies have used this approach to build an impressive portfolio of products and services.
In some cases, because of patent protection, trade secrets, or the difficulty of obtaining industry certifications, companies are forced to acquire technologies and product lines instead of investing in-house. Substituting in-house R&D with acquisitions is a great strategy to build scale and diversify the technology portfolio, but it comes with significant risks. I believe a healthy combination of M&A and R&D capital allocation helps companies achieve sustainable growth and profitability.
Typically, public companies spend anywhere from 2 to 5 percent of their revenues on R&D. Companies that invest in R&D stay ahead of the technology curve, better serve their customers, and build a moat around their business models. In the long run, investors tend to value organic growth over M&A because of its lower risks of execution. Several industry experts have noted that more than 50 percent of M&A deals do not achieve their intended purpose. Don’t get me wrong: I am not diminishing the role M&A plays in achieving growth and diversification, but I think it is important for business leaders to spend more time thinking about investing internally and actively managing R&D initiatives.
Investing in-house to build competencies and capabilities to design, build, and successfully launch new products and services will help build a competitive edge. Companies with a dedicated technology platform serving dedicated vertical market customers are better off innovating through in-house R&D because of their deep knowledge of their customer base. In my experience, I have seen companies with too many R&D projects. They struggle to prioritize and invest in the right programs to manage both short-term and long-term growth aspirations. It all boils down to picking the right bets on critical technologies that will significantly move the needle on growth and performance and add tremendous value to customers. So, how does one go about doing this?
There are various metrics to measure R&D investments. One of the most popular is the vitality index, which measures the percentage of revenues coming from new products and services in any given year. Metrics are good, but as we know, they can be skewed to show false progress unless managed properly. A rigorous approach to identifying, managing, and launching R&D projects helps companies achieve strong growth. A methodical approach to R&D based on markets and customer input is key to overall success.
Many companies have developed proprietary tools and processes for managing R&D programs and new product development (NPD) processes. Honeywell uses a system called Velocity Product Development (VPD), which ties product development to sales growth. Many industrial companies use the popular Stage-Gate process, which was developed by Stage-Gate International. In this approach, product development is put through a five-stage process from ideation to launch. The project moves from one stage to the next with a rigorous go/no-go decision-making process and by completing a set of activities and analysis to improve the effectiveness and efficiency of the entire system.
When we launched this process in one of the companies I previously worked for, I noticed we had more than 100 ideas competing for limited R&D capital. Some were pet projects of certain individuals, some were sponsored by our sales team to hit their sales quota, and some were genuinely game-changing ideas. We had to go through a rigorous analysis of all the ideas, which involved multifunctional teams, seeking market and competitive information to assess the value of each growth idea to the enterprise and our customers.
For the Stage-Gate process to work effectively, it is important to engage senior leadership and the key stakeholders responsible for delivering the projects. We held monthly technology reviews with senior leadership and cross-functional teams where we debated vigorously to make sure the right projects were funded. Given the competitive nature of industrial businesses, I often challenged the team on whether we could achieve an appropriate level of return on our investments. If an NPD idea came from a specific customer, I would challenge the team to partner with and seek investments from the customer or, even better, ask the customer for a memorandum of understanding to purchase the product after we launched it.
All of this sounds like common sense, but you would be surprised at how often this process is mismanaged. Once the projects were chosen, we made sure they were managed efficiently to completion with regular documented updates. We were prepared to say no to many projects when it didn’t make commercial or business sense to invest in them. These best practices allowed us to make significant progress on our R&D investments. However, there are challenges related to investment cycles, establishing global R&D centers, and building a dedicated R&D team, which I discuss below.
As with any good investment, we need to manage both the short-term and long-term aspects of R&D investments. Some projects take years to materialize, whereas others can be completed and launched within months. During tough economic conditions like what we are facing now, leaders are tempted to cut investment in R&D, but if companies are planning for the long term, they should resist this temptation. At times we pick a project that might cannibalize other products, and that has to be considered in the decision-making process. When companies do not have all the information to make informed decisions but there is pressure to invest in a particular program, they may adopt the “fail fast and fail cheap” approach — a quick and cost-effective way to test out new ideas. Finally, involving functional teams from sales, marketing, manufacturing, supply chain, human resources, and engineering helps company leaders make smart decisions on investments.
We see large multinational corporations establishing R&D centers in low cost countries (LCC) such as China and India. However, low cost is a misnomer, because the cost of doing business in these countries is rising, and the level of collaboration required between different operating centers takes considerable time and effort. Rushing to establish R&D centers in LCC, with only cost in mind, will not help a company achieve its goals. Smart companies think about R&D holistically to build technical competencies and capabilities globally with the intent to innovate quickly and launch global products and services efficiently. When I was managing an LCC manufacturing center in the Middle East, we moved our engineering center of excellence to India to better manage the cost profile and improve the efficiency of using a large existing engineering base. Ultimately, it comes down to using the diverse brainpower to network within their respective global organizations to find solutions to customers’ most difficult problems — today and in the future.
In his new book, Winning Now and Winning Later, David Cote, retired CEO of Honeywell, talks about Honeywell’s journey to establishing Honeywell Technology Solutions (HTS) centers in India, China, and the Czech Republic. David’s challenge was to persuade Honeywell leaders to rapidly increase the R&D in developing countries and to travel to those locations to observe the quality of work. He also viewed R&D centers as not just technology centers but as a footprint to expand locally with a deeper knowledge of local markets and customers. Over time, the company established a strong team of ten thousand employees at HTS, and the company not only benefited from this strong technology team but was able to generate $11.5 billion of organic growth during his tenure.
When companies get large and complex, it is typical for them to appoint a chief technology officer (CTO) who controls the R&D budget and all aspects of technology, innovation, and new product development. This makes sense, but where companies miss out is when they don’t build a culture of cooperation and collaboration between the CTO office and the operating units. When I was leading operations in Asia and the Middle East, I noticed local teams being pulled into R&D projects led and managed by leaders elsewhere in the world, with little to no input from the local teams on the projects’ viability. It was a real drain of valuable resources. To extract more value from R&D investments, it is important to break the silos within the company and tightly integrate the CTO’s team with operating divisions, including the regional teams.
Bottom Line
As a growth leader and an M&A professional, I understand and appreciate the need to use M&A to achieve growth and diversification. But this should not come at the cost of not investing internally in R&D and NPD programs to achieve organic growth. A balanced approach to strategic M&A and R&D investments helps companies build a competitive edge in the marketplace. Putting strong process rigor around technology innovation helps companies get more value for their investments. Finally, building a culture of collaboration between the technology team and operating divisions is key to achieving growth through innovation.
