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Home Opinion The need for ‘customer pull’ in innovation policy
Innovation • Economy • Technology

The need for ‘customer pull’ in innovation policy

David Connell - 12 February 2015

There is a need to boost the ‘demand pull’ for innovation to complement the existing ‘technology push’ from research

Now the starting gun has gone for the longest election campaign in UK history, we can expect the majority of the debate to centre on voters’ lives and pockets: jobs, wages, taxes and public services. But if we are to sustain an economy that pays decent wages and can afford to provide the public services we expect, we must also have effective policies to help rebalance the economy and create high-skill jobs in new export-orientated companies.

The latest balance of payments figures released just before Christmas underline the size of the challenge. Since 2011 the overall current account deficit has fallen from two per cent to six per cent of GDP, and the deficit of trade in goods was worse than in any quarter for three years.

An effective innovation policy is one of the keys to reversing this trend. Part of the UK’s problem is that we actually have two innovation policies, each largely based on flawed assumptions.

The first is run by the Department of Business, Innovation and Skills. Despite the introduction of some new thinking by Vince Cable, its spending, management and policies remain dominated by the research councils, which spend 90 per cent of its R&D budget. So innovation policy tends to be treated as an extension of science policy, focusing on measures to make university research more applied and commercialise it through ‘translational research’ and spin-outs.  In other words ‘technology push’.

The success of the Cambridge cluster is often used to illustrate why this makes sense. But the reality is that none of Cambridge’s most successful companies in terms of jobs are based on university intellectual property. Instead, solving problems for larger organisations has been the main stimulus for innovation, with R&D contracts for lead customers acting as a key source of early-stage funding.

A incremental model

Rather than being based on a major scientific breakthrough, backed by massive venture capital investment, the dominant success model is a more incremental one, with expertise, finances and reputation developed over a period of years through companies undertaking paid contracts for customers before developing and marketing their own proprietary products and accelerating growth. This model is sometimes known as the ‘soft start up’. By delaying, or even avoiding, significant venture capital investment it also enables the entrepreneurial team to retain control over business strategy and pursue a longer-term vision than might otherwise be possible.

In contrast, university research spin-outs tend to adopt a model that is much more dependent on venture capital from the start. Even when a company succeeds technically, this is nearly always followed by it being sold to a larger corporation, often based overseas. This is usually before the business has moved much beyond the R&D stage, so further growth is truncated or worse. This pattern is particularly visible in the UK biotech sector, on which much of government innovation policy spending is focused.

The ‘soft-start-up’ strategy is replicated across the science, technology and engineering sectors, and it is not just restricted to the UK.

James Dyson only moved into manufacturing and marketing vacuum cleaners after 11 years, during which he operated a development and licensing business. Products based on his bagless technology were sold by partners in the UK, Japan and US. Arm, Cambridge’s most successful technology company was a soft start that was spun out of Acorn Computers after its founders had developed a revolutionary chip for its parent, and later Apple, as customers. Acorn itself was also a soft start; its success came from winning the BBC Micro contract. So was Cambridge Antibody Technology, the UK’s most successful biotech company, now part of AstraZeneca. Vodafone, the UK’s most successful start up since the war, was a spin-out from Racal, a UK electronics company that started as a two-man technology development consultancy.

And in the US, Bill Gates started in business by developing software for computer hardware companies. It was several years before a contract to supply the MS/DOS operating system for the IBM PC gave Microsoft the chance to sell the same software to PC clone manufacturers. Intel’s success is based on a product it originally developed for a Japanese calculator company. Porsche was a soft start up. So was SAP, Europe’s largest software company.

If the UK is to create more Dysons, Arms and Vodafones to rebalance the economy, it must create an environment that supports the early stages of this natural ‘soft-start-up’ model.

The UK’s second innovation policy is run by the Treasury. Here thinking is dominated by two fundamental principles. The first is that government should not do anything that could be accused of  ‘backing winners’. The second is that government should only intervene where there is market failure. This has resulted in policies to subsidise R&D expenditure by UK-based businesses in the hope that they will spend more themselves. The most costly of these, R&D tax credits, has been steadily extended in scope since it was introduced in 2001 and now costs the exchequer £1.4bn pounds a year, around four times what BIS spends on R&D grants to businesses.

But over this same period, net business R&D spending, after deducting tax credits, has actually decreased by some 14 per cent when measured as a percentage of R&D – much more even that the cost of the R&D tax credit programme.

Part of the reason that R&D tax credits are not delivering the economic benefits expected is that companies do not have to change their behavior to benefit. The cash that results can be spent as readily on foreign acquisitions or dividends.

And R&D tax credits would have done nothing to help the founders of Racal, Acorn and Dyson. Without significant revenues or venture capital funding they simply did not have the matching income. Most innovative start-ups are in a similar position today.

Customer innovation contracts

So customer innovation contracts are not just the best source of funding for most start-ups, they are also often the only one. The role of the public sector is particularly important, as it does not usually need to retain any intellectual property created or restrict subsequent sales, unlike most private sector customers. The breadth of government’s activities means it can fund R&D contracts as a lead customer across a wide range of advanced technologies, from materials and cyber-security, to energy, healthcare and scientific instruments. And the endorsement a government R&D contract brings greatly improves the ability of companies to sell overseas, recruit employees and attract partners and investors.

Both the US and German governments have put innovation contracts at the centre of their innovation policies.

In Germany the government covers around 70 per cent of the costs of its network of Fraunhofer Institutes, non-academic R&D organisations whose main role is to develop technology for German industry. R&D contracts from industry provide the customer pull and the remaining 30 per cent of the funding. The UK’s Catapult centres are expected to emulate this approach, but without Germany’s broad industrial base to act as paying customers, achieving equivalent economic impact in the UK will need a different approach. Complementary policies will be required to provide customer pull, particularly through SMEs and Catapult spin-offs.

Innovation policy in the US is largely implemented through procurement. Federal agencies have a voracious demand for new technology, either for their own use of for policy reasons. Unlike UK government departments they also have a culture of placing contracts with businesses and the budgets to fund them.  This has underpinned the creation of a wide range of major US companies in industries ranging from computing to robotic surgery.

The UK’s misnamed Small Business Research Initiative, established under the last Labour government, is based on the most visible of these US programmes and it is now awarding around £70m in R&D contracts a year. Its phased approach concentrates funding on the most promising projects and it is the only UK innovation scheme that gives early stage companies 100 per cent funding in amounts large enough to make a difference to their prospects.

SBRI projects funded by the NHS, one of the main players, include new treatments for age-related blindness and diabetic ulcers, new diagnostic devices, and technologies to help patients self manage their conditions at home.

However, total SBRI spending falls far below the chancellor’s commitment and important departments like the Ministry of Defence are not yet participating. Unlike R&D tax credits and Catapults, there has been no new money for the programme.

As in all areas of public expenditure, we cannot afford policies that do not deliver good value for money. We need more R&D spending, not less, but whatever the make-up of the next government it should manage the innovation budget across the government as a whole and focus it on the part of the innovation process where it can have the greatest impact. This means innovative start-ups and SMEs, together with higher-risk new ventures in larger corporations, rather than the kind of routine R&D any company needs to renew its product lines.

Lead customer funding, to provide demand-pull for innovation alongside the technology push from research, is the best way to achieve this. The next government should shift a significant part of its business innovation spending into programmes that will achieve this.

David Connell is an entrepreneur and senior research fellow at the Cambridge Judge Business School’s Centre for Business Research
This is a contribution to Policy Network's work on Progressive Capitalism.

Tags: David Connell , Innovation

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