In the dynamic landscape of startups, strategic investment in research and development (R&D) is crucial for sustained growth and innovation. However, distinguishing between 'Research' and 'Development' and balancing investments accordingly can significantly impact a startup's success.
In my previous article, Incorporating the R&D Breakdown into Your Equity Story, I touched on this topic. Based on feedback, this article delves deeper into the distinction between research and development in R&D investments, offering concrete benchmarks and visual insights.
Research vs. Development
Research focuses on exploring new knowledge and generating novel ideas, often with long-term horizons and uncertain outcomes. Development applies these findings to create marketable products and services, emphasizing short- to mid-term gains and practical implementation.
The Importance of Balance
Startups often struggle to allocate resources between research and development. Over-investing in research can delay revenue generation, while an excessive focus on development might lead to incremental improvements rather than disruptive innovations.
Benchmarking R&D Investments
To achieve an optimal balance, it’s essential to benchmark R&D investments against industry standards while creating separate calculations if necessary to avoid misleading benchmarks.
1. R&D Percentage of Revenue: Top innovators typically invest 10-15% of their revenue in R&D, as highlighted in the PwC Global Innovation 1000 study. Startups, particularly in their MVP stages, can spend more than 85% of their total expenses on R&D. As products mature, this percentage declines. See Exhibit 1 for a detailed breakdown of R&D expenses relative to total operating expenses.
2. ProductLife Cycle and Investment “waves”: At the MVP stage, research may constitute about 85% of total R&D costs. This percentage decreases to around 35% in the maturity stage and eventually declines to nearly zero as the product enters the decline phase. Each product create a separate “wave” and should be measured separately. CEOs should be aware of these variations before benchmarking. It's crucial to start investing in the second “wave” before the first “wave” reaches its maximum potential to ensure continuous growth. Exhibit 2 illustrates the clear distinction between these “waves” for a more accurate comparison.
3. Research vs. Development Ratio: Traditionally, a 40:60 ratio is a good starting point, with 40% of the R&D budget dedicated to research and 60% to development. However, this ratio should be adjusted based on the startup's maturity, market conditions, and strategic goals. It’s important to evaluate this ratio for each product separately to avoid misleading conclusions. See Exhibit 2, which demonstrates that measuring the research-to-development ratio at the start at the stage of "wave 2" can result in a misleading average. This is because it combines products at different maturity levels: the first “wave” (in blue), in the scaling stage, has research expenses around 40% of the respective R&D, while the second “wave”(orange), in its MVP stage, requires over 80% of the respective R&D expenses for research. Using an average between those, is misleading.
The correct measure is each “wave” on its own (see Exhibit3), and also to make a comparison of how the total R&D looks as a benchmark(see Exhibit 1).
Based on my extensive experience, I recommend adopting milestone-based funding for R&D projects and distinguishing between product "waves". This ensures resources are allocated effectively based on progress, reducing the risk of over-investment in unproductive areas. Embrace both research and development as key components of your equity story.
