The following is a guest post from Laurent du Passage, CFO at Quadient. Opinions are the author’s own.
Investing in research and development is a critical driver of growth and innovation for tech companies. New data shows the top 50 global companies increased their R&D spending by 6.5% in 2023, investing a total of ≈$526.3 billion (€504 billion), which accounts for 40.1% of the total R&D investment by leading firms. This substantial investment underscores the critical role of R&D in maintaining competitive advantage and fostering sustainable growth in the tech industry.
This raises the question: How does a business size and prioritize R&D investments from a financial perspective? As CFOs, we must carefully balance big-picture strategy, risk management and ongoing evaluation to ensure the outcome of our R&D spend contributes to sustainable growth and competitive differentiation.
However, any CFO in a tech company knows there can be a tremendous amount of uncertainty inherent in research and development. Because of that, the decision to invest R&D dollars into a project requires a full understanding of the business case and the means required to execute it.
Size up the opportunity
The first step to determining the viability of an R&D project does not start with a technical requirement but with a customer need. This might seem like a simplistic approach, but many projects mistakenly start with trying to develop an offering similar to the competition’s or a technology-oriented development. Defining precise customer pain points leads to assessing market potential and related market growth rate, as well as assessing which new technologies have the potential to deliver greater returns and under what timeline: the what, how and when.
From that market assessment, the fair market share you expect to capture and the technical resources and time you need to build your asset will drive how much revenue the R&D expenditure could generate in relation to how much the project costs are and, more importantly, for how long. This equation needs to factor in marketing costs and SG&A required to deliver the proper go-to-market, which typically includes sales, marketing, legal, accounting, IT and human resources.
Another point of entry is figuring out how much customers will pay for the product, i.e. the average selling price. Since most software is sold as a subscription, particularly with the software-as-a-service model, ASP would be expressed per annum. It is also important to determine how long customers will maintain their license when projecting potential revenue, translating to lifetime value. Then compare this to the project’s total cost to determine its financial feasibility, where your minimum return rate should be your weighted average cost of capital.
Factor in contingencies and reassess assumptions
One thing to keep in mind as a global company is that just because the numbers work on a spreadsheet doesn’t mean they will work in real life. Potential sensitivity to key parameters must be well-tested: time to market, R&D investment overruns (usually underestimated), underlying market growth and market share gain (usually overestimated). Those will all have a significant impact on the return rate; hence, significant contingencies need to be built, but, more importantly, milestones and metrics must be established beforehand.
This will allow stakeholders to review at each milestone the decision to continue moving forward, making adjustments or terminating the project. In my experience, even a well-planned and well-engineered R&D project can go off track if it doesn’t meet the needs of the market, regardless of the quality of the code or the product.
Making financial decisions about R&D investments should be a collaborative effort across business units and cross-functional teams for the best results. However, one must always remember to keep emotions out of this process and make decisions based solely on facts. The temptation may be strong to continue a project for the sole reason that a lot has been invested in it already.
However, ultimately, the decision may come down to whether the business case still makes sense or not — or whether we are pouring money into an R&D project that is no longer financially feasible. If we find the latter is true, it is time to terminate the project and devote the resources to where they can generate a positive ROI.
Build, buy or partner?
Instead of building an R&D project organically, there are times when it is more feasible to acquire a company that has already done the research and development for the outcome you are seeking. Acquiring another company can decrease the risk and allow for a faster time to market, but often at a potentially higher cost and can bring technical and operational integration challenges.
Here, a business case must be built to determine whether it is worth paying the premium to lower your risk and potentially boost your return. When you are missing a specific technical asset that is not your core business but is an enabler to selling your product, you should consider partnering.
Globally, some of the risk factors I have discovered that go into making R&D decisions from a financial perspective include:
Market maturity and demand: Is the market mature and demand strong? If so, this lowers the risk. If the product is being sold globally, this answer may vary by region.
Product marketing and routes to market: Is there current expertise on how to package, market and sell the product or will there be a steep learning curve on the part of staff?
On-staff expertise: Does current staff possess the knowledge required to launch the project, or will you need to hire employees with the needed expertise?
Based on the answers to these questions, you can rate your project risk as low, medium or high. The level of risk will dictate the level of return expected for the R&D project. If the risk is high, for example, your minimum expected ROI might be 20% instead of 10%. If the risk is low, you might be willing to accept a lower ROI, closer to your weighted average cost of capital.
Managing shareholder and investor expectations
One challenge many companies face when prioritizing R&D investments from a financial perspective is how to best manage shareholder and investor expectations. Clear communication about any investment decision is critical.
Explaining the investment strategy to shareholders and investors, the assumptions that have been made, and showing the milestones and metrics that dictate your decision-making process is crucial for building trust in the decision. This helps stakeholders understand how the company plans to allocate resources, manage risks and achieve growth while demonstrating accountability through measurable progress.
R&D is essential for businesses seeking to expand beyond their core products. The key to a successful outcome is prioritizing R&D investments early in a project and carefully evaluating all relevant factors. While this requires careful planning and timing, it can lead to substantial long-term returns.
