Fostering bottom up innovation

I go to lots of meetings in Washington on innovation. Most of the time we are bemoaning the lack of an innovation policy in this country and wondering what it will take to get the US back on track.
My major complaint is that invertible, when it comes time to propose possible solutions, we fall back on the stand answers: more funding of R&D, train more scientists and engineers, and create an infrastructure that allows them to collaborate better (both social and hardware infrastructure).
That’s fine for top-down innovation — innovation that comes out of the research lab. But as a 2002 RAND study pointed out, the innovation system is much broader and deeper than that:

we immediately think of scientists and engineers working sometimes on their own but most often in laboratories or R&D facilities operated by private industry, by universities, and to some extent by the government. Yet, much innovative activity occurs outside the formal precincts of R&D labs. R&D departments tend to be an artifact of large firm organization. But in all company settings much “fixing” that amounts to innovation is done on the line by employees not principally charged with the innovation task. This type of informal activity too is an element of the national innovation system.

Another major source of innovation is users. Virginia Postrel’s column yesterday in Business > Innovation Moves From the Laboratory to the Bike Trail and the Kitchen” href=””>the New York Times, “Innovation Moves From the Laboratory to the Bike Trail and the Kitchen” reviews Eric Von Hippel’s leading edge work in this area:

When most people think about where new or improved products come from, they imagine two kinds of innovators: either engineers and marketers in big companies trying to “find a need and fill it” or garage entrepreneurs hoping to strike it rich by inventing the next big thing.
But a lot of significant innovations do not come from people trying to figure out what customers may want. They come from the users themselves, who know exactly what they want but cannot get it in existing products.
“A growing body of empirical work shows that users are the first to develop many, and perhaps most, new industrial and consumer products,” Eric von Hippel, head of the Innovation and Entrepreneurship Group at the Sloan School of Management at the Massachusetts Institute of Technology, wrote in “Democratizing Innovation,” recently published by MIT Press.

Unfortunately, we don’t really understand the policies that could foster bottom-up innovation. In his book, Von Hippel outlines the public policy problem:

An important first step would be to collect better data. Currently, much innovation by users-which may in aggregate turn out to be a very large fraction of total economic investment in innovation-goes uncounted or undercounted. Thus, innovation effort that is volunteered by users, as is the case with many contributions to open source software, is currently not recorded by governmental statistical offices. This is also the case for user innovation that is integrated with product and service production. For example, much process innovation by manufacturers occurs on the factory floor as they produce goods and simultaneously learn how to improve their production processes. Similarly, many important innovations developed by surgeons are woven into learning by doing as they deliver services to patients.
Next, it will be important to review innovation-related public policies to identify and correct biases with respect to sources of innovation. On a level playing field, users will become a steadily more important source of innovation, and will increasingly substitute for or complement manufacturers’ innovation-related activities.

Von Hippel makes suggestions in four areas:
1) Intellectual Property Rights, where he raises the concern that the current IPR regime is too restrictive.
2) Constraints on Product Modification:

Current efforts by manufacturers to build technologies into the products they sell that restrict the way these products are used can undercut users’ traditional freedom to modify what they purchase. This in turn can raise the costs of innovation development by users and so lessen the amount of user innovation that is done.

3) Control over Distribution Channels:

Users that innovate and wish to freely diffuse innovation-related information are able to do so cheaply in large part because of steady advances in Internet distribution capabilities. Controls placed on such infrastructural factors can threaten and maybe even totally disable distributed innovation systems such as the user innovation systems documented in this book.

4) R&D Subsidies and Tax Credits, were the bias is toward manufacturers-innovation rather than user-innovation:

important innovative activities carried out by users are often not similarly rewarded, because they tend to not be documentable as formal R&D activities.

While this is an interesting list of issue, I think it probably only begins to scratch the surface of our policy bias toward top-down innovation.

One end note: Von Hippel also warns of the challenges to National Competitive Advantage:

Nations may be able to create comparative advantages for domestic manufacturers with respect to profiting from innovation by lead users; however, they cannot assume that such advantages will continue to exist simply because of propinquity.

In other words, in an era of global manufacturing, just because something was invented here, doesn’t mean that it will be produced here. That is another dimension that we take into consideration as we development a comprehensive innovation policy.

Eminent Domain and Intellectual Property – update

In a posting last month, I mentioned a bill in the DC City Council to use eminent domain to control the cost of drugs. Apparently, the bill’s sponsor, David Catania has backed off of the eminent domain argument – see Washington Examiner: News:

Catania, I-at large, on Tuesday circulated a substitute bill that eliminated the eminent domain provision.
He replaced it with language that makes it an “illegal trade practice” to overprice medications.
The substitute authorizes the city to use its “broad police powers” to regulate commerce, Catania said. If a medication’s price is determined to be excessive under the District’s Consumer Protection and Procedure Act, the mayor could request a compulsory license as a “remedy,” Catania said.
A hearing would then determine whether the drug maker loses its patent.
Ross Weber, Catania’s spokesman, said the substitute was introduced to “avoid the stickiness of eminent domain” – the practice of taking private property, in this case intellectual property, for public use.

The question still remains — is a patent “property” that can be seized (with fair compensation) by a local government. Or is a patent a Federally granted monopoly right.

Google and the irrelevance of GAAP

Yesterday’s Wall Street Journal Heard on the Street column contained a very interesting quote in its story on Google’s pre-IPO accounting for stock options (as background GAAP is Generally Accepted Accounting Practices — the set of accounting rules that US companies must use in their financial statements):

“On the surface, it makes the numbers look more favorable on a GAAP basis,” said Youssef Squali, an analyst at Jefferies & Co. in New York. But, he said, when comparing Google’s core financial performance to its rivals, “GAAP is the last thing you’d use,” because of the diverse factors, such as options expenses, it takes into account.

If GAAP is the last thing that analysts use for comparing companies, then what is it good for? As the Financial Accounting Standards Board (FASB) puts it:

Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information. Financial information about the operations and financial position of individual entities also is used by the public in making various other kinds of decisions.

In other words, investors need a clear set of standards with which to judge investment opportunities. The whole purpose of GAAP is to provide a consistent set of financial measures across companies.
When analysts start saying that GAAP is irrelevant to judging a company like Google, then we know our accounting system is clearly broken.
(More later when I publish my paper on Reporting Intangibles.)

Financial risk and lack of an innovation policy

Recently, the question has arisen whether the US laws promote or discourage risk taking. There are a number of ways to approach this question and a number of laws that could be scrutinized. It is interesting to look at two areas that affect financial risk to see how the debate has approached the issue of innovation: one where innovation is at the forefront of concern and the other where innovation was almost completely ignored. Where innovation has been discussed is the issue of new corporate accounting rules under Sarbanes-Oxley. Where it has been almost ignored is the recently passed changes to the bankruptcy laws.
The contrast is striking and points to the lack of an innovation policy in this country. If we had a functioning innovation policy, we might be able to look at all these areas — rather than the hit or miss approach where the issue is raise in one circumstance, but ignored in another.
The first issue is the growing concern about the new corporate accounting regulations under the Sarbanes-Oxley Act. There is a rising tide of rhetoric that the regulations are too burdensome, specifically Section 404 that requires companies to document and certify their internal financial reporting procedures and controls. Even before, there was concern about another section of the Act, Section 302 which required the CEO and CFO to sign a certification that the report was not untrue or misleading under penalty of criminal prosecution. This, we were told, was putting a chilling effect on innovation. An example of this argument is Peter Wallison of AEI, “Blame Sarbanes-Oxley”:

An array of stimulus factors has failed to generate strong growth in the U.S. economy. That may largely be a consequence of the Sarbanes-Oxley Act and the stock exchange regulations it has spawned, which have altered the composition and dynamics of corporate boards in ways that discourage risk-taking.

The concern over innovation was acknowledged by SEC Chairman William Donaldson (in a 2003 speech) when he said:

I also hope that America’s corporate leaders will not use Sarbanes-Oxley as an excuse for putting off innovation and investment.

Some argue that the concern over Sarbanes-Oxley is overblown. According to Ben Worthen, writing in CIO Magazine, A Funny Thing Happened on the Way to Compliance (It Got Easier):

Everyone thought the Sarbanes-Oxley financial disclosure act would require CIOs to perform heroic feats of integration, spend fortunes on software and invest enormous amounts of sweat equity. Now, with the law reinterpreted, only the last appears to be true.

Others argue that the requirements under Sarbanes-Oxley present an opportunity. As John Parkinson and Stewart Bloom writing in Optimize Magazine, Understanding Law > Surviving Sarbanes-Oxley > June 2003″ href=””>”Surviving Sarbanes-Oxley”

From Enron to MCI, extreme accounting practices and poor management judgment have shattered investor confidence. That’s why Congress passed the Sarbanes-Oxley Act of 2002, “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.” To survive, publicly traded companies now must re-establish investor confidence. And their CIOs have a new role to play in building and selling technology strategies to support that mandate.

Regardless of where you come down on the issue of Sarbanes-Oxley (and I personally believe that the negative impact is overstated), the issues of innovation and risk-taking are front and center.
The debate over the bankruptcy laws stands in stark contrast. As the The Economist puts it, the cure may be worse than the disease. They note that

while Europeans might be bemused at all the moral outrage in America over the latest reforms, they might also wonder why Americans are so eager to move their bankruptcy law closer to Europe’s-especially since Europe is busily trying to emulate America. Until around 20 years ago, consumer bankruptcy didn’t even exist in many European countries, and corporate bankruptcy was a draconian process too dreadful for all but the most desperate managers to contemplate. Since then, these nations have relaxed their laws precisely because they see the economic benefits this has brought America.

The Economist goes on to look at the pros and cons of tighter bankruptcy laws:

Making bankruptcy harder tends to make borrowers more willing to lend, but consumers less willing to take on debt. The result is that interest rates-the price of credit-fall. At first blush, this would make it seem that Europe had the right idea in the first place; the vast majority of people and companies that never declare bankruptcy get better terms on their loans, while the few profligates are forced to watch their step.
But making bankruptcy more difficult has other, less attractive economic effects. Forced repayment plans can discourage people from working harder (or at all), since extra income simply goes to pay creditors. Making bankruptcy more unpleasant can also deter entrepreneurship; people starting businesses are often required to personally guarantee loans to their firm-and those without assets are often forced to rely on MasterCard and Visa for their seed capital (see article). Tougher corporate-bankruptcy rules seem to make companies more risk-averse. America’s current permissive system does let many (possibly undeserving) managers keep their jobs, but it also saves workers and suppliers from a sudden loss of income.

The article they refer to cites recent academic work, including Wei Fan and Michelle J. White’s Personal Bankruptcy and the Level of Entrepreneurial Activity. That study used the differences in state bankruptcy laws, specifically the “homestead exemption,” to test the relationship between the bankruptcy laws and entrepreneurship. To the surprise of no-one who has studied entrepreneurship, they found that more tolerant laws promote entrepreneurship:

The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as consumers, because debts of non-corporate firms are personal liabilities of the firms’ owners. If the firm fails, the owner has an incentive to file for bankruptcy, since both business debts and the owner’s personal debts will be discharged. In bankruptcy, the owner must give up assets above a fixed exemption level. Because exemption levels are set by the states, they vary widely. We show that higher bankruptcy exemption levels benefit potential entrepreneurs who are risk averse by providing partial wealth insurance and therefore the probability of owning a business increases as the exemption level rises. We test this prediction and find that the probability of households owning businesses is 35% higher if they live in states with unlimited rather than low exemptions. We also find that the probability of starting a business and the probability of owning a corporate rather than non-corporate business are higher for households that live in high exemption states.

As I said, this finding comes as no surprise to those of us who have been following entrepreneurship. The international comparison study of entrepreneurship, the Global Entrepreneurship Monitor (GEMI) has routinely stated the same thing. In fact, their 2001 National Entrepreneurship Assessment of the Untied States raised the warning:

In early 2001, versions of the Bankruptcy Reform Bill passed through the House and Senate. The bill is designed to reduce the number of personal bankruptcy filings submitted each year in the United States by requiring the payment of some portion of debt determined under court supervision. Proponents feel reform will protect small businesses from debtors while opponents argue that large credit card companies will reap the benefits of such legislation.
The current movement to reform bankruptcy laws could seriously affect entrepreneurship in the United States. As one of our experts stated, “bankruptcy reform is sending entrepreneurship in the wrong direction” because it is discouraging risk.

I remember very clearly listening to a well-known entrepreneur explain to a luncheon of Congressional staff how he built his business my maxing out multiple credit cards. That was a few years ago – and apparently none of that staff is still working for Congress, because those issues were not at the forefront of the debate.
Now, not everyone agrees that these changes will be bad for entrepreneurship. For example, Professor Jeff Cornwall, Director of the Center for Entrepreneurship at Belmont University, is not all that concerned. As he writes, when he teaches entrepreneurship,

I want them a little afraid at their start-up. I want them a little nervous. I want them a little worried about what happens if they fail. Entrepreneurs who rush in blindly like marauding pirates have not learned the lessons we try to teach them in our classes.
. . .
If Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 causes folks to think twice about their business idea, that to me is a good thing. If one of their main exit strategies is a quick and easy bankruptcy, then I want them to either rethink their plan or start over. Or if they are one of my students, plan to take the class again next semester.

He may be right – I disagree.
But the fact is that these issues were not at the center of the debate. The House Judiciary Committee report on the bill (House Report 109-031 – Part 1) does not include the word “innovation” and only has one paragraph on entrepreneurship, in the minority (dissenting) report. This just shows how far we are from having a functioning innovation policy.

Patents and innovation research

This morning, the National Bureau of Economic Research (NBER) is holding a conclave of economists who study innovation. (For those of you who don’t know it, NBER is the premier economic research organization — it is an NBER committee that determines when recessions officially began and ended).
While the conclave is by-invitation-only, unlike the Papal conclave we don’t have to watch the color of the smoke to know what is happening. The papers are posted on the NBER website at NATIONAL BUREAU OF ECONOMIC RESEARCH, INC
One of the most interesting papers is by Adam Jaffe of Brandeis University and Josh Lerner of Harvard University. The paper “Innovation and its Discontents” is an extension of the 2004 book by the same title: Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, and What To Do About It.
Their thesis is simple:

In the last two decades, however, the role of patents in the U.S. innovation system has changed from fuel for the engine to sand in the gears. Two apparently mundane changes in patent law and policy have subtly but inexorably transformed the patent system from a shield that innovators could use to protect themselves, to a grenade that firms lob indiscriminately at their competitors, thereby increasing the cost and risk of innovation rather than decreasing it.

Some of their recommendation, especially concerning business methods, software and biotechnology patents, will likely generate debate. Others, such as pre-grant opposition and re-examinations of granted patents, seem to be part of the building consensus on patent reform.
This paper/book is just the latest in a series of reports on the need for patent reform. Last year, the National Academy of Science published its set of recommendations: A Patent System for the 21st Century (Report of the Committee on Intellectual Property Rights in the Knowledge-Based Economy). The year before the Federal Trade Commission came out with To Promote Innovation, The Proper Balance of Competition and Patent Law and Policy.
And interestingly enough, at the same time as the NBER meeting was taking place, a few blocks away the Trans Atlantic Consumer Dialogue was holding its own day-long session on patent reform “Patents for Poets and Policy Wonks.”
Let us hope that Congress is paying attention.

From technology to information

Last Friday, the stock market took a nose dive on the news that IBM will miss its expected quarterly profits. The report forced down the price of shares of other tech companies, as analysts took this to mean tough times ahead in the computer industry. But, as analyst Mark Stahlman noted in an interview in Business Week (The Old IT Is Dead. Long Live the New), the real problem isn’t macroeconomics:

Q: Why are IBM and so many other companies missing their earnings numbers? Is it macroeconomic factors or a structural shift in information technology?
A: The macroeconomics are really only important when there’s nothing important happening in the technology. When the technology is lively and there’s some significant product or architectural transitions coming, that always trumps the economy. We’re in a period of really intense technology change — probably the most concentrated period of technology change yet.

In other words, there is still a lot of disruptive innovation yet to come. Companies who are hoping to sit back and cruise along based on their current technological capabilities are in for a rough ride.
IBM seems to be one of the companies that understanding the need to change and remake itself. It is trying to transform from a technology company to an information company (see the cover story of a recent Business Week: Beyond Blue):

Over the past two years, Palmisano has built these concepts into a strategy that would be laughable — if it weren’t so serious. His goal is to free IBM from the confines of the $1.2 trillion computer industry, which is growing at just 6% a year. Instead of merely selling and servicing technology, IBM is putting to use the immense resources it has in-house, from its software programmers to its 3,300 research scientists, to help companies like P&G rethink, remake, and even run their businesses — everything from accounting and customer service to human resources and procurement.

Why remake the company? Because, as Michael Dell preaches and practices, information technology is be coming a commodity. It is the application of information where value-added now lies.

IBM, with its legions of PhDs and closets full of patents, is not built to duke it out with the likes of Dell. Palmisano’s strategy promises a neat escape. Instead of battling in cutthroat markets, he takes advantage of all the low-cost technology by packaging it, augmenting it with sophisticated hardware and software, and selling it to customers in a slew of what he calls business transformation services. That way IBM rides atop the commodity wave — and avoids drowning in it.

What does it take to re-orient from technology to information? Working with the client in a high-tech, high-touch relationship. For example, as the BW story relates:

In its pursuit of vital industry experience, IBM — much like an eager college intern — is sometimes willing to work for free. IBM’s unpaid partnership with the Mayo Clinic dates back to a cocktail party in 2000 in Mayo’s hometown of Rochester, Minn., where IBM has a computer factory. A Mayo employee and an IBMer realized that scientists at both companies were working on genomics research. This soon led to joint projects on gene profiling of leukemia cells, and a published paper in a scientific journal in 2003. This is not the kind of connection that Dell, Accenture, or Wipro is likely to make.
IBM and Mayo quickly moved on to a more ambitious project: changing the way medical research is done. They set out to gather data on 4.5 million patients and to make it easily searchable by researchers — but without compromising patients’ privacy. A research task that used to take five people a year can now be done by one person in 15 seconds. Eventually, Mayo and IBM believe, physicians will tap into a vast storehouse of data, real-time, when they’re diagnosing patients. “This is the way to transform the way we practice medicine,” says Dr. Nina M. Schwenk, chairperson of Mayo’s Information Technology Committee. And for IBM, it’s a foot in the door of the $1.4 trillion health-care business.
While IBM had plenty of skilled engineers in Rochester, they practically needed brain transplants if they were to do breakthrough work for Mayo. So the company sent some of its brightest engineers back to school. Working with the University of Minnesota, the company arranged in 2003 for a series of three-day crash courses in everything from molecular biology to protein sequence analysis. So far, 50 people have taken the classes. Nothing illustrates more starkly the gyrations at IBM: Engineers who once worked on a fading family of mainframe-style computers are now helping to chart the future of medicine.
. . .
A lot of these newfangled service deals haven’t been around long enough to show results — but a few have. At Nextel, for instance, IBM’s takeover of the company’s customer-service operations helped improve its customer satisfaction ratings from also-ran to top of the heap. P&G is another success story. In January, 2004, IBM took over part of P&G’s human resources in a 10-year deal valued at $400 million. P&G has so far outsourced 3,500 jobs, including some in computing and customer relations. In HR, it had set 21 standards for speed and accuracy in such categories as payroll and expense management. The IBM-run operations met them all. In the month before IBM took over, P&G had met only nine of the goals, according to market researcher Gartner Inc.
With those victories under its belt, IBM is scrounging for new markets. In addition to its four original businesses — accounting, HR, customer service, and procurement — it is now plowing into six others. They include after-sales service for consumer electronics, insurance-claims processing, and supply-chain optimization.

Will this work? That remains to be seen. Both the service side and the technology side were responsible for IBM’s missed quarterly performance. As Chief Financial Officer Mark Loughridge was quoted in the Wall Street Journal (“IBM Results Fall Short of Targets As Companies Slow Tech Spending”):

at least some of the weakness in mainframes was expected, in part because the machines sold very well in the prior year.
Mr. Loughridge also placed blame for the shortfall at the feet of the giant services organization, which accounts for about half the company’s revenue. Those services encompass everything from handling a company’s payroll operation and designing computer networks to basic consulting.
Mr. Loughridge said IBM had “execution issues” in services, and that the company was beginning restructuring efforts, largely targeted to Europe, that would try to clean those up.

Clearly, IBM has ways to go in its transformation. We will see if Wall Street has the patience to see it through.

China faces a labor shortage?

Companies moving operation’s to China are running into a familiar problem: lack of qualified workers. According to The Economist:

Though China has a vast pool of unskilled labour, firms in the south now complain that they cannot recruit enough cheap factory and manual workers. The market is even tighter for skilled labour. As the economy grows and moves into higher value-added work, the challenge of attracting and retaining staff is rising with the skill level, as demand outstrips supply. The result is escalating costs for firms operating in China. “If you think that China is a cheap place for labour, think again,” says Vincent Gauthier of Hewitt Associates, a human-resources consultancy.
The particular shortages mentioned most often are of creativity, of an aptitude for risk-taking and, above all, of an ability to manage-in everything from human resources and accounting to sales, distribution, branding and project-management.

The solutions that companies are turning to sound very familiar:

Bonuses, longer-term incentives, free housing and meals, a mobile phone and a set of wheels are becoming standard perks. More than one-third of 1,600 multinational firms surveyed by Hewitt now offer a company car. More holidays, maternity and paternity leave, more frequent job rotation and share options also now feature. Add in the big contributions that employers must make to China’s national security fund system and the total cost of an employee can be double his basic pay.
Above all, Chinese employees want good training, as they are acutely aware of the limitations of their educational system and keen to acquire marketable skills. Ping-on Mak, senior human resources manager for GE Consumer Finance in Asia, says that the attitude of many young Chinese managers is “if I want training, I’ll go work for a multinational and then after three years I’ll leave.” But GE, with an in-house “university”, and L’Or&#232al, which provides mentoring, say that training produces employees who tend to stay longer.

Two points jump out from this story:
1) modern production systems are no longer (if they ever were) simply a case of putting done a factory in the middle of a low cost labor pool. There are numerous other skills that are needed to run a modern system. I’ve talked to companies doing business in China for a number of years – and the technical and managerial problems are immense.
2) China is clearly moving up the value-added chain as evidences by their concern over having more “creative” workers. For the US to build a lasting advantage on the engineering and creative side will be an ongoing challenge. If a product can be traded, the Chinese will be in the market.
One other point from the Economist story about company responses to the problem is also interesting:

Some foreign firms hope to persuade the expatriates they send out to stay longer than first planned-despite their higher cost. Some are relocating operations from the coast to smaller, cheaper cities to tap new markets for talent. Some are even considering outsourcing from China itself, by moving parts of their operations to, say, Vietnam and Cambodia, where the workforce is even cheaper and younger.

Vietnam and Cambodia? Last I heard at least Vietnam was worried about Chinese textiles overrunning their own nascent textile industry. I had always heard of Vietnam as moving further up the value-chain – not becoming China’s maquiladora. More on this later.