IT Management: Take the innovation initiative

There are a number of potential transaction models for acquiring and developing innovative technology, each with its own benefits and challenges.

Laurence Jacobs and Nicholas Smith

Businesses face heady decisions when it comes to acquiring and updating their technology infrastructure. Should they try a do-it-yourself approach with in-house IT staff? Should they outsource the work? Or should they take a more strategic route such as partnering with other providers?

Whichever approach seems to fit, it’s imperative to keep their technology up-to-date or risk falling behind in product development, customer service or corporate reputation. Planning for technology innovation and deployment projects requires careful mapping of strategic objectives, deliverables and realistic work-around options.

Companies should take a broad view of how they go about fulfilling technology initiatives. There are a variety of transaction models companies can use to develop new technologies and to leverage existing infrastructure. Each has its relative strengths and weaknesses in fostering technology innovation:

• Individual acquisition: Using its own employees and in-house resources gives a company full control of a project. However, it must also fully bear the risks if a new technology is delayed or fails.
• Traditional outsourcing: A company doesn’t have to execute a project on its own, but outsourcing often limits access to innovative technologies.
• Acquisition: This can be a quick way to get new and innovative technology, but it can take time to integrate new systems with the company’s existing infrastructure.
• Joint ventures: Companies can lower their costs by sharing technology development, but they also must share control.
• Collaboration agreements: These agreements are an alternative to traditional joint ventures. Each party acts as both a customer and a service provider to one another. These agreements are complex and need to be carefully written and executed.
• Patent pools and innovation incubators: These collaborations let companies share development and cross-license their research results. These agreements also need to be carefully drafted.

Go it alone

Perhaps the most intuitive approach to technology innovation is for a company to undertake projects using its own employees and other in-house resources. There are many positive aspects to this traditional approach:

• The company has full control of the project and can ensure compliance with company protocols and project work plans.
• The company retains all benefits of a successful project.
• The company can gain a competitive advantage by achieving vertical integration.
• The company can customize project work activities and technology specifications as appropriate.
• The company avoids having to manage a relationship with a third-party services provider or strategic partner whose interests are not fully aligned with its own.

There are, however, significant disadvantages to undertaking a technology innovation project as an in-house matter:

• In-house development and deployment can be costly and slow.
• If the new technology is found useful in a product or service outside the company’s established offerings (or outside the needs of a company’s existing customer base), the innovating company must then develop new products and customer bases to monetize the innovation.
• It’s often difficult for a non-technology company to compete for the best technology resources at competitive rates.
• The ability of a company to customize innovation efforts can actually become a disadvantage if the company has excessive customization requests (resulting in delays, more complex and high-risk deliverables, and project cost overruns).
• A company going it alone must bear all the risk of a delayed or failed technology development effort.
• Intense involvement in technology development is often an unwelcome distraction from the core business activity (for non-technology companies).

Against this backdrop, there are other transaction types that foster technology innovation while mitigating the downside risks and costs associated with technology development projects.

Traditional outsourcing

In a traditional outsourcing agreement, the customer relies on a services provider to provide relevant expertise to implement technologies outside the customer’s core functions. Outsourcing is a proven and powerful tool to achieve cost savings and technology standardization. The outsourcing model has notable deficiencies, however, as means by which to drive technological innovation.

Outsourcing agreements typically feature detailed descriptions of services and related technology as a way to ensure continued cost savings while maintaining acceptable quality of service. To facilitate that level of detail, the relevant technology must already be available. The focus then is efficient implementation, not technology innovation.

Outsourcing arrangements are rarely structured to promote innovation. Services providers want to retain sole ownership and control of as much technology as possible to leverage across their customer base.

Innovation via acquisition

The most expedient and low-risk way for a company to gain access to innovative technology can sometimes be to buy another company with innovative technology. Facebook’s recent $1 billion acquisition of photo-sharing application Instagram is a good high-profile example of this. Facebook faced two key challenges regarding photo sharing in its core business:

1. Increasing competition from other photo-centered social media services, such as Pinterest.
2. The growing market perception that the Facebook mobile experience was clunky and not improving despite the company’s efforts to improve it.

By acquiring Instagram, Facebook addressed both issues in a single stroke and bypassed future in-house development. Facebook has subsequently made a smaller acquisition of Face.com for the same reasons.

This type of innovation via acquisition can have a quick and significant impact, but it has its own set of challenges. First, the acquiring company must complete complicated and detailed work post-acquisition to integrate the acquired technology. Second, the acquired technology can underperform or be riddled with unforeseen liabilities, such as burdensome customer service contracts. Due diligence and strong post-acquisition project management can help mitigate these risks. Under the right circumstances, acquiring strategically valuable technology can be a critical tool in overall technology development strategy.

Joint ventures

Many companies foster technology innovation by forming joint ventures with other companies. The joint venture model addresses many of the challenges associated with in-house efforts and outsourcing transactions:

• Joint venture partners can share the costs and risks of large, complex and expensive technology development projects.
• Joint venture partners can play to their strengths while shoring up weaknesses by leveraging the expertise of another party.
• The joint venture structure creates a shared economic interest to encourage partners to make and share their best efforts.

The most fundamental characteristic of a joint venture—the shared economic incentives, costs and risks—helps establish a framework to encourage innovation and sharing. Joint ventures can also have significant drawbacks a company should consider and take steps to mitigate:

• All partners should expect to sacrifice control and flexibility regarding all assets and technologies.
• Joint ventures can be increasingly trying and difficult to manage over the long term as business needs evolve and the interests diverge.
• Joint ventures are often set up with a focus on strategic upside, with insufficient attention on managing the day-to-day aspects.
• Disputes between joint ventures can be notoriously difficult to resolve.

Dissolving a joint venture established without serious advance exit planning is a particularly sticky affair. You have to reallocate ownership of intellectual property and other assets, manage customer relationships, manage and allocate enduring liabilities and litigation, and so on. Any party considering a joint venture should engage in serious and detailed advance planning for dispute resolution and termination options, including associated exit rights and transition-support obligations.

Strategic alliances

An alternative to the traditional joint venture model is a collaboration or strategic alliance. Such arrangements often take the form of a complex services agreement. Each party acts as both a customer and services provider. Strategic alliances of this type result in integrated products or services each party would be hard-pressed to develop and market on its own.

Strategic alliance partners should describe in detail each party’s rights and responsibilities, in much the same way a customer purchasing outsourcing services would demand detailed service descriptions and service-quality protections. Give particular emphasis to contract governance and third-party customer management, so partners can track brewing issues and modify their efforts to meet changing business needs.

Companies can achieve innovation through the collaboration model by letting each party focus on improving its core technologies. When acting as a services provider to strategic allies, each collaborator benefits from a committed and interdependent customer to offset costs to develop improvements to core technologies.

Each collaborator benefits from the technological innovations of other collaborators as the services become more consistent and of higher quality. Along the way, all the collaborators benefit from the revenue generated from the third-party customers of the collaborators.

Strategic alliance agreements can be complex, so detailed planning and documentation are required. Issues relating to customer relations, revenue splitting, cost and liability allocation, confidentiality and ownership of newly developed intellectual property can prove particularly challenging in such collaborations. Some key questions include:

• Should one party or both be the face of the integrated offering to other customers?
• What if customers demand they deal with one provider, effectively requiring that one collaborator is the subcontractor of the other collaborator?
• How should revenues and responsibility for costs be split between collaborating entities?
• If a customer purchasing the integrated services offering of a strategic alliance brings a claim against one or both of the collaborators, how should that liability be allocated?
• Collaborating parties will need to disclose confidential information from time to time. What confidential information may be disclosed, and under what circumstances?
• If the innovative technology is genuinely created via a joint effort, who should own the licenses, intellectual property and royalty rights? How does that ownership change if the collaboration is dissolved?

Work out all these issues and clearly set such guidelines forth in a collaboration agreement to avoid later conflict and unpleasant surprises.

Innovation incubators

Companies in industries marked by expensive research efforts and lengthy product development timelines—such as pharmaceutical companies—have a particular need to mitigate the costs and risks of early-stage research. Some companies have collaborated by cross-licensing intellectual property, coordinating research efforts and sharing research results. These collaborations are sometimes called “innovation incubators” or “patent pools.”

Each participant should engage in joint reviews of research outcomes to determine whether particular research should be shelved, given additional funding for further joint development, or allocated for further in-house development.

Careful allocation of intellectual property ownership, licenses and royalty provisions in such arrangements is essential. Despite the complexity of the intellectual property aspects of this strategy, the innovation incubator model has proven a valuable tool for companies faced with daunting research and development costs.

An additional wrinkle to the innovation incubator model is that because these patent pooling arrangements often involve collaboration between entities that are otherwise competitors, participating entities must be mindful of antitrust regulations. As a result, any company considering this model should complete a review of relevant antitrust regulations in advance.

The right tool

Companies, technologies, industries and market conditions vary widely. The strategic benefits and challenges for each transaction model presented here can serve as a basis for a clear-eyed appraisal of a company’s technology innovation needs and capabilities. Of course, detailed planning and documentation must follow to implement these strategic decisions at a practical level.

Companies should take a wide view of how they go about innovating key technologies and products. They can acquire or benefit from innovative technologies in any number of ways. Innovation will always be a challenge, but companies need not go it alone.

Laurence Jacobs is global head of the Technology & Outsourcing Group at Milbank, Tweed, Hadley & McCloy LLP, based in London and New York.

Nicholas Smith is a partner in the Technology & Outsourcing Group at Milbank, Tweed, Hadley & McCloy LLP based in New York.

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