Seeking Funding for an Internet of Things Project?
“Too expensive”; “Very long time to a positive cash flow”; “We do not consider any project with ROI time longer than 18 months”. These are some of the typical responses and pushbacks early adopters of Industrial Internet of Things (IoT) technology often encounter when they seek funding from corporate management.
Indeed, almost every market study of IoT adoption ranks concerns about rosy, yet unconvincing return on investment (ROI) as one of the top hurdles to enterprise-wide adoption of IoT.
Admittedly, many green-field IoT projects require significant investments over an extended period of time: designing new products, creating a network infrastructure, and establishing new business and customer relationships models. Although falling hardware prices, availability of cloud-based IoT services, and a growing number of IoT platforms make plunging into the IoT water easier, more economical and less risky, for many, long-term ROI remains elusive.
But should the Industrial Internet of Things be considered just yet another IT project, like implementing a new ERP system? Or does an investment in a promising technology and new business constructs warrants a different, more strategic, approach?
Irreversibility and Uncertainty of IT Investments
Companies must innovate and make investments in technology to improve efficiencies, be more competitive, and drive profitable growth. Yet, it can be extremely difficult to decide which technologies to invest in, when to adopt them, and how to manage the implementation process in order to realize the anticipated business value.
There are two challenges associated with large IT investments: the irrecoverable cost of the project, and the uncertainty about the timing and the magnitude of the value returned.
Irreversibility, or sunk cost, of the investment stems from spend on hardware and software, training and learning, and implementation and deployment.
Cloud-based software helps reduce direct expenditure on hardware and software, training, and implementation. But other unavoidable and irreversible costs associated with large IT projects, such as staff hiring and training, employing consultants, and absorbing productivity losses during the business transition, can easily dwarf direct capital expenditure.
Uncertainty results from the unpredictable evolution of a new technology, the ability of the organization to exploit it effectively, and the willingness of customers and business partners to adopt it.
At an even more foundational level, there’s uncertainty in how new technology will impact the rest of the organization. Will it disrupt and cannibalize exiting profitable businesses? How will it impact the rest of the IT portfolio and its future direction?
Traditional methods to calculate return on investments, such as net present value (NPV) and discounted cash flow (DCF), don’t work well for investments that are associated with high degree of uncertainty and irreversibility. These methods tend to understate the potential value of strategic investments, and that greater uncertainty at the outset often indicates greater future value.
When considering an early investment in new and promising technologies, such as Industrial IOT, it is advantageous to view it through a real options lens.
Real Options
Real options approach sees initial technology investments, such as creating a proof of concept, a prototype or a pilot project, as enabling future “growth” options. These options confer the right, but not the obligation, to realize future benefits from subsequent deployments of that technology or its derivatives.
This notion is similar to financial call options that confer the right, but not the obligation, to obtain benefits from future ownership of traded securities. When using real options to evaluate a technology investment, the cost of the initial investment is the “price” paid to obtain the set of future options. Each follow-on project is evaluated separately as a different option.
This notion should not be entirely foreign to product companies. These companies make routine investments in innovation and core R&D, in the hope of exercising future benefits created by further developing and deploying new products.
Determinants of Option Value
If the idea is to defer future value realization, how can the organization determine the potential value of future options?
Option value can be viewed through the lens of broad categories that incorporate an external perspective of market position and competitiveness, and an internal innovation and growth perspective.
Market Advantage
Companies make technology investments to drive higher level of competitiveness and business advantage in the marketplace. The option value is determined by the degree to which the expected improvements in products or services establish a sustainable market advantage and provide effective barriers to entry against existing and future competitors.
Greater competitive advantage and radical innovation aimed at business disruption increase the variance of future returns, and, consequently, the option value of technology investment.
Innovation Culture
Organizations vary dramatically by their ability to innovate and manage the innovation process all the way to effective and profitable deployment. The organization’s innovation culture and process maturity, and its ability to marshal technical, financial, human, and organizational resources, determine the future value of innovation.
Furthermore, a mature innovation-oriented culture confers a higher level of flexibility in selecting and exercising future options, thereby increasing the option value of the proposed investment.
Platform Foundation
Knowledge and experience gained during the development and deployment of a new technology create a foundation upon which subsequent implementations create yet a higher-level foundation, which, in turn, enables higher level of innovation, operational optimization, and market advantage.
This platform increases the organization’s capacity for effective incremental innovation: flexibility to pursue follow-on investments incrementally in unforeseen areas that are yet to develop. Greater flexibility and reusability potential increase the expected value of potential returns and the corresponding option value.
Learning Potential
Related to the innovation culture of the organization and its innovation platform foundation, is the extent to which the organization possesses the capacity to maximize learning and to exploit it continually and effectively.
Companies that excel in continuous learning and knowledge reuse tend to innovate more rapidly and economically, and with a greater likelihood of success, which increase potential returns and the option value of technology investments.
Real Options Valuation
Investing in Industrial IoT technology is clearly a strategic long-term decision.
Companies view the Industrial Internet of Things as a radical technology and business innovation aimed at business disruption. They are considering investment in IoT to benefit from the sweeping range of operations improvements, new business opportunities, and innovative customer-engagement models enabled by a network of smart, connected devices.
Worth noting here, however, that some scholars differentiate between radical innovation, as a technology-centric innovation at the opposite of incremental innovation, and disruptive innovation, as defined by Clay Christensen, which focuses on a new business model, but doesn’t necessarily require a technological breakthrough. The Internet of Things and IoT-centric business models offer both.
The real options approach is a qualitative evaluation method that can help managers determine the most strategically-valuable path to pursue and prioritize the different options enabled by the IoT platform. It encourages long-term strategic thinking and underscores the future value that will be obtained from early investments in technology.
Even when a traditional ROI method is used, a systematic and objective qualitative evaluation of the factors in the proposed model will provide a good framework to help managers priorities and budget projects to maximize the potential for high option value.
Real Options and IT Platform Adoption: Implications for Theory and Practice
This article is based on the work of Boston University professor Rob Fichman. I have simplified the concepts outlined in his Real Options and IT Platform Adoption: Implications for Theory and Practice quite drastically, in the hope that the principles are easier to follow and implement.
Image: The Moneylender and His Wife (detail) (Quentin Metsy, 1514)