The Innovation Subsidy

When Microsoft Corp. finally launched its much-awaited and long-delayed Windows 95 operating system in mid-1995, it was remarkably free of crippling bugs, something in which the company’s technical managers understandably took great pride. Indeed, Microsoft executives confirmed that the operating system had cost “hundreds of millions of dollars” to develop. But here’s what they didn’t mention: The world’s wealthiest software firm had consolidated its market position and greatly enhanced its equity valuation with Windows 95 by, in effect, negotiating a billion-dollar subsidy from many of its best customers and developers.

How so? As part of its product development process, Microsoft had sent out roughly 400,000 beta version copies of Windows 95 to thousands of beta sites worldwide — individuals and organizations willing to help track bugs and suggest improvements in exchange for receiving the software in advance, influencing its development and getting help with any problems that might arise. In so doing, Microsoft essentially drew upon a highly valuable technical population the size of a major city to help improve the quality and capabilities of its new operating system. Even the most conservative back-of-the-envelope calculations reveal this to be an astonishing transfer of wealth.

Assume, for argument’s sake, that one-quarter of the beta versions never got tested or were used in ways that were worthless to Microsoft. That leaves 300,000 beta versions being tested on desktops around the world over several months. At a conservatively estimated cost of $3,000 per version, this means that Microsoft’s final stage of Windows 95 development was effectively subsidized to the tune of $900 million — far more than Microsoft itself invested. Without question, this subsidy enabled Microsoft to produce a far better product for far less money in far less time than it otherwise could have. That’s a powerful business model. Consider how much more competitive an Alcoa, a DuPont or a GE Plastics might be if they received the equivalent of a nearly $1 billion subsidy from Toyota, General Motors and Ford to develop innovative lightweight materials for auto bodies.

A Gray Market

This suggests a provocatively counterintuitive perspective for competitive enterprises. The dominant challenge for the innovative firm may not be to command marketplace premiums for its innovation but to strategically identify and opportunistically exploit subsidies of that innovation. An innovation subsidy may be defined as the deliberate donation of a business resource — money, time, information, expertise, personnel, equipment — in support of the development of a novel offering with no explicit expectation of a financial return. To paraphrase Nobel laureate economist Milton Friedman, however, there’s no such thing as a free subsidy. What may look and feel like outright donations in reality constitute gray-market, non-financial transactions among individuals and institutions seeking to cost-effectively barter resources. Neither Microsoft’s Windows 95 beta sites, nor the secretaries who received free samples of 3M Co.’s new Post-It notes, nor pharmaceutical companies that provide tissue samples to medical school clinical labs expect a financial return, but they do expect to extract value from the interaction.

When the Gillette Co., for example, gives away thousands of Mach 3 Turbo razors to promote its innovative triple-bladed shaver, the consumer-products giant is asking males to donate time and their faces to test the new product. Although the product is ostensibly free, recipients must choose to risk nicks, cuts or an inadequate shave. Confidence in the Gillette brand may mitigate some of the consumer’s perceived risk. In the final analysis, the transaction is this: Gillette must persuade Mach 3 Turbo prospects that the value of its subsidy to them is significantly greater than the risk of their subsidy to Gillette. The value of that subsidy differential creates a rationale for both parties to take a chance on the innovation. That approach —not unlike Microsoft’s — invites creative cross-subsidy that can be migrated and marketed into profitable innovation adoptions.

Such scenarios are clearly not merely about money, but about creating and managing relationships that tap the resources of a company’s savviest customers. Not incidentally, the rise of the Linux operating system and other open-source software as a rival to Microsoft reflects a similar approach. Indeed, as researchers such as MIT Sloan School of Management’s Eric von Hippel and Harvard Business School’s Siobhàn O’Mahony have shown, open source innovators are driven less by the need to acquire proprietary profit than by the desire to collaboratively create robust communities that interactively solve one another’s development problems. In the management of innovation risk, social capital can be as valuable as financial capital.

The Cross-Subsidy Chain

Seeking out the innovation subsidy challenges firms to rethink the underlying economic relationships between their customers and suppliers. Is the innovator likely to get a greater “return on subsidy” from getting a supplier to machine-tool a provocative design at a deep discount or from persuading half-a-dozen favored clients to beta test an unfinished product? Both in theory and practice, a firm’s entire supply chain could be reinterpreted along the dimensions of identifying opportunistic subsidies where customers or suppliers might be given incentive to support the innovation initiatives of the enterprise. Firms would, of course, also need to be aware of where they were subsidizing others’ innovation initiatives. This pattern of the innovation cross-subsidy chain would offer keen insight into the nature of the firm’s risk-management culture.

But where do opportunities for innovation subsidies arise? Excess capacity offers one answer. A company with excess production-line capacity, consumers with extra time, intermediaries with extra data, IT departments with unused computing capacity — all are targets from which to solicit subsidy because their risks revolve around manageable marginal cost, and the opportunity costs of subsidizing the innovation process would be correspondingly low. By contrast, a capacity-constrained software developer or manufacturer invites a different kind of opportunistic subsidy: It might very well be willing to give away process flow models and production data to potential suppliers that might offer innovative approaches on how to boost capacity. The core differences in perceived and real risk among economic entities represent the richest source of ideas for opportunistic innovation subsidies.

The key insight here is that subsidy is not bribery; it’s a deliberately designed market mechanism for mitigating risk. Clients being sold exotically innovative financial instruments by cyber-powered Wall Street quants from Goldman Sachs or Citigroup are frequently given the very same analytic tools and simulators that are used in-house to develop them. Clients are more likely to trust the innovative instruments if they can test them on their own terms. Similarly, IBM Corp. and other major software players give away or offer below-cost development tools to business partners that are developing the more innovative applications and IT services. These firms want to reduce both the costs and risks associated with getting their partners to commit significant resources to them.

In practical terms, the innovator’s search for subsidy and the empirically demonstrated desire to create gray-market cross-subsidies reflects the reality that while seeking high rewards for high risk is the most glamorous side of innovation, the pragmatic innovative enterprise seeks subsidy as assiduously as it seeks profitability. For successful innovators, history suggests the two are synonymous.