How EBITDA killed innovation


What kills innovation in companies?  What makes a young, growing company stop in its tracks and stay fixed there?

Often, it has something to do with EBITDA.

EBITDA is a company’s earnings before interest, taxes, depreciation, and amortisation – which helps to determine a company’s operating profitability.

Many tech companies regularly trade innovation and long-term gains for a better EBITDA measurement or to boost their share position.

But this can have disastrous long-term effects on a company’s ability to innovate.

In the tech sector, where innovation is the underlying basis of any business, being able to quickly respond to trends and changes in the market, however, unprofitable they may be in the beginning, is critical to long-term success.

Amazon is an often-cited company when it comes to innovation; refraining from generating any profits over a number of years in order to build a business which would eventually dominate its market.

This ability to think long-term and dominate a market can often be down to the funding structures in place behind the company.

Forbes reports that VC backed companies have less focus on EBITDA, instead choosing to focus on the ‘race for long term market dominance’.  Yet, private equity firms who usually come in after a VC are more conservative and risk-averse in their outlook, instead using EBITDA as a measure to determine business performance.  Finally, once the company is listed publically, there is market pressure to achieve targets and report performance to shareholders on a quarterly basis.

This stops companies from thinking about how they could invest their precious cash in innovative, blue-sky thinking.  Companies who are focused on EBITDA due to a pending merger, acquisition or are having to meet quarterly targets to satisfy shareholders, don’t have the room to take risks and instead end up stagnating, doing the same thing with the same resources; and wondering why their business isn’t flourishing or changing.

Investing for the future.

Whilst investment in innovation can impact on short-term financial goals and make the company appear less profitable, innovation is critical to making sure the company is profitable, or at the very least making sure it exists, in 2 – 3 years’ time.

Think about all the technologies that have wiped out their predecessors.  Vacuum companies who haven’t invested in cordless technology may be out of business in 2 years’ time when the market shifts to cordless devices.  Car manufacturers who haven’t spent money on R&D for electric vehicles may be a few years behind their competitors and unable to compete effectively over the next 10 years.

Too good to ignore

Without innovation, the business relies on its run-rate business – the customers who purchase now because it’s ‘what they have always done’ until a disrupter comes along and takes the decision away from them and the new alternative is too good to ignore.  In standard businesses, that rate of change could take place over 10 – 20 years.  Service led businesses could offer the same types of services for decades (i.e. lawyers, accountants) however in the technology business, your product is more damaging in the tech sector than any other industry.

This has led a number of tech businesses moving away from the pressure of quarterly earnings calls and forecasts, to concentrate on sustainably growing their business.  Dell recently took the decision to go private while it figured out its place in the new competitive world of enterprise technology and cloud.    Google also recently spun off a number of its business segments so that it could better focus on each area, and be able to invest heavily in certain businesses without hampering the performance of its run-rate search engine business.

Google also recognised that this adherence to EBITDA performance can choke creativity.  Without the room to fail and risk money on a project, great things rarely happen.

Many of the larger tech companies are even scaling back the labs which once made them great, in order to reduce operational expenditure.  Unbeknownst to many in the tech business, some of the multinational tech businesses have (or did have) large lab facilities where researchers would develop innovative new ideas; many that would not fit into the company’s portfolio but might be able to be sold off as a patent or idea elsewhere.  For instance, HP developed its print technology into high-tech skin patches that ‘print’ onto the skin rather than inject.  What inventions are we missing through our inability to focus on long term growth over short term gains?

However, a relentless focus on EBITDA goes beyond just stifling innovation, it can also seep into a company’s culture, making the persistent quest for efficiency and profitability a recipe for culture disaster.  Many next generation start-ups lose their quirky office perks once they are acquired – on a balance sheet that weekly pizza and beer session on a Friday afternoon makes little sense but on the sales floor it can make the difference between staff staying or leaving a company.

Which brings me to my final thought.  We often say that smaller companies are able to innovate quickly due to their flexibility and size – making them able to pivot and change course without tiers of management to wade through.

But maybe that ability to innovate is less to do with the structure, because after all, having the resources of an IBM or Microsoft must be an enabler to innovation.  Maybe the innovation killer is actually more to do with the fact that once a company generates a significant level of interest or revenue, the focus on its EBITDA position overshadows all of its other dynamic and entrepreneurial pursuits in favour of the share price.

 

 

Image provided courtesy of UCL.

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