In today's rapidly changing business environment, innovation is essential for survival. However, many companies may find innovating difficult, even when they want to, especially for incumbent firms that have been in business for a while. Investors in such incumbent firms often have short-term investment horizons and may be myopic in assessing complex, long-term projects. As a result, such companies are caught between a rock and a hard place: while they need to innovate to survive, they may only be able to afford to do so with the support of investors. This article explores the challenges incumbent firms face in pursuing digital innovation and provides recommendations for overcoming these obstacles.

Investors often affect investments in innovation 

Many management researchers have emphasised that the failure of incumbents (the more mature and steadily profitable firms) to innovate when technologies and markets change is not dependent upon the newness or complexity of the technology. Often, their acute focus on the needs of important existing customers constrains their response.  

A study by Deepa Mani, Professor of Information Systems, Anand Nandkumar, Associate Professor, Strategy, and Anandhi Bharadwaj, Emory University, published in the Harvard Business Review found that not just customers but another key stakeholder group, the firm’s investors, may also impede technological innovation by incumbents.   

According to the research, when investors value incumbent and mature firms for their profits, they are less likely to invest in digital innovations and offer lower market valuations, measured by the P/E ratio, to firms investing in innovation.  

For example, IBM, a well-established technology company, has struggled to maintain investor confidence as it pivoted towards cloud computing and artificial intelligence. In 2015 IBM had to hire external advisers to deal with restless investors as it struggled to transform the company from a low-margin hardware maker to a cloud-based software and services business.

Another point the research brings out is that when investors value a firm for its growth potential and not profit, they are more likely to invest in digital innovations and obtain higher market valuations. Investor enthusiasm is greater for the innovation efforts of disruptors, startups, and tech giants than their enthusiasm towards innovation efforts by incumbents.  For instance, Amazon, a company known for prioritising growth over profits, has consistently attracted investor enthusiasm, with a P/E ratio of more than 290 in June 2023, despite low profitability. Hence, incumbents are largely valued for current period profits, whereas disruptors are valued for future growth. Therefore, the runaway available to each of these firms to create innovation is different.

Let’s look at how investors in different companies reacted to innovation efforts due to this challenge. Tesla's market capitalisation (USD 64.75B) on Aug 7, 2018, overtook BMW's (USD 64.36B), despite the latter’s comparable production levels and electric car deliveries and much higher profits (net income of 10.3B for BMW versus -2.7B for Tesla as of June 30, 2018). Despite this, investors showed more optimism about Tesla's future growth while hailing its technological innovation efforts.

Similarly, General Electric was once the flagbearer for digital innovation. However, investors were looking for something other than radical innovation from GE, and it had to cut down on its efforts to transform the business into a digital powerhouse. In 2017, GE's CEO Jeff Immelt left GE, saying that “…in our core businesses, earnings have tripled during my tenure, we have record-high market share, financial performance has outpaced that of our peers…we have paid more in dividends than during the previous 110 years of GE history combined; nonetheless, our P/E ratio has gone from 40 to 17… and the stock price has underperformed. Thus it is with transformation.” 

Challenges Incumbents Face 

Incumbents often face significant challenges from their investors as they embark on their journey to digital innovation. Investors in incumbent companies, who are primarily focused on the firm’s profits, may be hesitant regarding efforts supporting the allocation of resources towards unproven technologies and disruptive strategies. As a result, substantial tension may arise between the incumbent's long-term vision for digital innovation and the short-term expectations of their investors.  

However, the nature of digital innovation necessarily involves a short-term decline in profits. Hence, when an incumbent company engages in digital innovation, performance follows a ‘U-curve’, i.e., profit will decline in the short term and eventually rise. Therefore, investors must be patient when the incumbent firm goes through that trough. In the case of a disruptor, where the focus is growth, investors are likelier to be okay with a short-term decline in profits or even losses.

Additionally, the pressure to maintain steady financial performance on a quarter-to-quarter basis can substantially constrain the incumbent's ability to experiment with new ideas and invest in the necessary infrastructure and efforts geared to encourage innovation. Hence, incumbents must strike a delicate balance between meeting investor expectations and pursuing transformative digital initiatives to help secure their competitive advantage in the rapidly evolving market landscape. This mismatch between organisational innovation priorities and investor patience even promoted Dell Inc. to go private so that it could focus on its long-term priorities.

Recommendations and Solutions 

Investors play a critical role in shaping a company's innovation strategy, and their behaviour can significantly impact the organisation's innovation efforts’ success or failure. By understanding the nature of complex, transformational innovation and the capabilities it requires, investors can help foster a more supportive environment for innovation. To succeed in their efforts to innovate, companies must work closely with their investors to develop a shared understanding of the importance of innovation and the long-term benefits it can bring.  

This requires a shift in mindset from short-term financial metrics to a focus on long-term growth and innovation. By working together, companies and investors can create a culture of innovation that drives success and growth in the long term.  

Below, we have identified a range of strategic recommendations that allows companies and their investors to forge a symbiotic partnership to overcome barriers hindering innovation, thereby unlocking unprecedented growth opportunities. Implementing these strategic recommendations and nurturing a collaborative partnership between companies and investors can decisively overcome the barriers impeding innovation. This momentous shift will unlock unprecedented growth and pave the way for a future defined by ingenuity, resilience, and sustained success.

Managing investor expectations assumes paramount importance. A prime example of this is embodied in Tesla's CEO Elon Musk, who has adeptly communicated the significance of innovation and the inherent risks of scaling up to investors even as it has matured from a disruptive startup to a major carmaker in its own right. By aligning investor expectations with the company's long-term goals, Musk has fostered an environment conducive to innovation. Tesla's remarkable success is evident in its market value, which now surpasses the combined market value of automotive giants such as FiatChrysler, Ford, and GM.

Exploring alternative sources of funding also emerges as a viable solution. In 2015, Pebble, a pioneering smartwatch company, deftly leveraged  Kickstarter's crowdfunding platform to raise over $20 million. This strategic move substantially reduced their reliance on conventional investors who might have harboured reservations about supporting ambitious, long-term projects. Pebble's astonishing crowdfunding success, surpassing its initial funding goal of $500,000 within a mere 49 minutes, is a testament to the immense potential of diversifying funding streams.

Reshaping investors' perception of innovation is an imperative that will help overcome investor resistance. Managers in incumbent firms should try to reset market expectations with the help of proactive and carefully calibrated communications to investors before pursuing digital innovation. Another option is for incumbent firms to develop creative arrangements or structures (such as spin-offs).

Unilever, in 2010, undertook a groundbreaking initiative known as the Sustainable Living Plan. This visionary programme aimed to enlighten investors about innovation's myriad benefits while highlighting the effect of stagnation in sustainable living. Unilever proactively collaborated with investors to foster the development of novel investment models inherently supportive of innovation. By instilling a profound appreciation for the pivotal role of innovation in driving sustainable living, Unilever sought to realign investor mindsets and cultivate an environment that champions bold and transformative initiatives. Additionally, Unilever has also consciously worked towards attracting more large institutional shareholders that align with its vision.

In Summary

Innovation is essential for companies to remain competitive in today's rapidly changing business environment. However, we often observe that incumbent firms face resistance from investors when it comes to adopting innovation. By understanding incumbent firms' challenges and adopting strategies to overcome these obstacles, companies and investors can work together to foster a more supportive environment for innovation and drive long-term growth.