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Where does innovation come from? For one answer, consider the work of MIT professor Eric von Hippel, who has calculated that ordinary U.S. consumers spend $20 billion in time and money trying to improve on household products—for example, modifying a dog-food bowl so it doesn’t slide on the floor. Von Hippel estimates that these backyard Edisons collectively invest more in their efforts than the largest corporation anywhere does in R&D.

The low-tech kludges of consumers might once have had little impact. But one company, Procter & Gamble, has actually found a way to tap into them; it now gets many of its ideas for new Swiffers and toothpaste tubes from the general public. One way it has managed to do so is with the help of InnoCentive, a company in Waltham, Massachusetts, that specializes in organizing prize competitions over the Internet. Volunteer “solvers” can try to earn $500 to $1 million by coming up with answers to a company’s problems.

We like Procter & Gamble’s story because the company has discovered a creative, systematic way to pay for ideas originating far outside of its own development labs. It’s made an innovation in funding innovation, which is the subject of this month’s Technology Review business report.

How we pay for innovation is a question prompted, in part, by the beleaguered state of the venture capital industry. Over the long term, it’s the system that’s most often gotten the economic incentives right. Consider that although fewer than two of every 1,000 new American businesses are venture backed, these account for 11 percent of public companies and 6 percent of U.S. employment, according to Harvard Business School professor Josh Lerner. (Many of those companies, although not all, have succeeded because they’ve brought new technology to market.)

Yet losses since the dot-com boom in the late 1990s have taken a toll. In August, the nation’s largest public pension fund, the California Public Employees Retirement System, said it would basically stop investing with the state’s venture funds, citing returns of 0.0 percent over a decade.

The crisis has partly to do with the size of venture funds—$1 billion isn’t uncommon. That means they need big money plays at a time when entrepreneurs are headed on exactly the opposite course. On the Web, it’s never been cheaper to start a company. You can outsource software development, rent a thousand servers, and order hardware designs from China. That is significant because company founders can often get the money they need from seed accelerators, angel investors, or Internet-based funding mechanisms such as Kickstarter.

“We’re in a period of incredible change in how you fund innovation, especially entrepreneurial innovation,” says Ethan Mollick, a professor of management science at the Wharton School. He sees what’s happening as a kind of democratization—the bets are getting smaller, but also more spread out and numerous. He thinks this could be a good thing. “One of the ways we get more innovation is by taking more draws,” he says.

In an example of the changes ahead, Mollick cites plans by the U.S. Securities and Exchange Commission to allow “crowdfunding”—it will let companies raise $1 million or so directly from the public, every year, over the Internet. (This activity had previously been outlawed as a hazard to gullible investors.) Crowdfunding may lead to a major upset in the way inventions get financed, especially those with popular appeal and modest funding requirements, like new gadget designs.

Citizen crowds have far less to offer in capital-intensive domains such as manufacturing, pharmaceuticals, and energy. Innovation in these sectors requires investments in the tens and hundreds of millions of dollars. What’s more, the payoff time is more often measured in decades than in months. Yet R&D funding in these industries is also in transition. Manufacturers, for example, are pooling resources with government help to try to gain an R&D edge in newer areas such as 3-D printing.

So what’s at stake in all this? The case of the pharmaceutical industry is instructive. In 2010, half of the top 10 corporate R&D spenders, including all of the top three, were drug firms. Yet despite huge budgets (in some cases $9 billion annually), the industry is famished for new products. It simply can’t get its R&D to pay off. Last year, the head of strategy for drug maker GlaxoSmithKline warned that if the innovation problem isn’t fixed, this might mark “the last generation of R&D spending” for large drug firms. The giant pharmaceutical research divisions, in other words, are in danger of getting cut back and broken up.

The drug industry’s answer is also to try to decentralize its spending. Glaxo is pushing nearly half its R&D dollars into the hands of academics and biotech companies, hoping they have the insight or intuitions it doesn’t. Other drug companies are doing the same, but the scale of pharmaceutical research spending is so big that the shift is taking years. Given the importance of drug research to human well-being, we should all hope they find the innovations they’re looking for.

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Credit: Oliver Munday

Tagged: Business, Business Impact, business, venture capital, venture capitalism

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